One of the more common questions in financial planning is how much to save for an emergency fund. It’s sort a personal question, really, I mean the answer to the equation is personal. Some people feel quite comfortable with three months of basic expenses set aside for a rainy day. Others, like me, have a goal to save one year of basic expenses in the event I lose my job, or am unable to work.
What are Basic Expenses?
Regardless of your goal in terms of the number of months you prefer to have saved, you must first conduct the important exercise of listing your current expenses, and then identifying which of those you would cut in an emergency. What’s left is often referred to as “basic” expenses. Consider things like electricity, car insurance, gasoline, food, and of course, rent or mortgage payments.
In my family we have agreed a number of things we pay for today could be easily dropped tomorrow if we lost our income. The gym membership would have to go. Cable and other entertainment options would be eliminated. I’d probably keep Netflix because streaming movies and television shows is such a cheap entertainment option. I’d also keep internet access and at least one cell phone active for job searching, networking, etc.
Conventional wisdom is that our monthly budget would actually go down considerably if we lost our income. Not so fast.
Accounting for New (Increased) Expenses
It wasn’t until I performed the exercise of listing our current expenses and then putting together our “emergency” budget that I realized our expenses would actually go up; not down. This concerned me because I had always assumed I needed less emergency fund since we’d be reducing our monthly expenses in an emergency.
I had not considered things like COBRA insurance, a costly way to keep health insurance coverage for up to 18 months (even longer, in some scenarios) after separating from your employer’s plan. I asked around and found out that COBRA can run as much as $1,500 a month for full family coverage. Essentially, you are paying both sides of the insurance premium, where your employer used to pick up a substantial portion of the costs.
Sure, you may be able to ultimately find a cheaper health insurance plan, but for the first month or two you are probably going to be preoccupried while scrambling to find work.
So even after cutting the cable, reducing our entertainment budget, and eating beans and rice all month, there was little chance I could make up for the increased costs of COBRA. But that wasn’t the only increased cost to consider.
Imagine if you were laid off in 2009, when gasoline for the average family worked out to about $173 a month. In less than a year, your monthly budget for gas budget would have increased to $281.06, an increase of over $100 a month. Sure, if you weren’t working you wouldn’t be commuting, but job hunting would still have you out and about burning gas. Today, many households are paying over $400 a month for gasoline.
Also be sure to account for food inflation. If your household grocery budget looks like mine, it seems we are constantly having to raise our food category. Not necessarily because we are buying more, but because the prices have gone up while the product sizes go down. Corn has almost doubled in the past 12 months.
When planning how much to keep in an emergency fund, don’t assume your post-emergency expenses will be significantly lower than your current expenses. In fact, it might make sense to save x number of months times a small increase to your regular expenses.
If you normally spend about $3,000 a month, and aim to save 6 months of expenses, normally you would anticipate a healthy savings balance of $18,000 to cover you. However, one could make an argument for rounding that up to $20,000, or even assuming a new $3,500 per month budget and saving $21,000 in an emergency fund.
I do believe you can save too much in an emergency fund, because money in excess of one year of expenses should probably be exposed to more risk, and therefore more opportunity for growth, than a money market account. However, I’ll finish this post the same way I started it–saving for emergencies is personal, based largely on your individual budget, and you and your family’s appetite for risk.
If saving 18 months of expenses helps you sleep better at night, then by all means, build that cash stockpile. If you and your spouse’s jobs are steady, you have other investments you could liquidate penatly free (Roth IRA contributions, etc.) and you’d like to only save up 3 months of expenses, then only save 3 months of expenses. Just be sure to save adequately for those three post-emergency months by not underestimating new expenses.