As much as we’d all like to, it’s impossible to stop adverse events such as job loss or sickness. If you don’t have the cash to cover an emergency, you’re taking a big risk.
You don’t want to find yourself in need of cash you don’t have, which is why you must have an emergency fund. While it can be hard to figure out how large that fund should be, this article aims to help you decide how much to save in case bad luck hits.
What’s the right amount to set aside?
It’s impossible to know how much an emergency will cost you, but it’s better to be over-prepared than under-prepared. Typically, it is advisable that your emergency fund contain enough money for you to live for about three to six months.
This should be calculated based on essential expenses you’d keep paying in times of hardship. Have enough to pay for housing costs, food, utilities, insurance, transport, debt payments, and personal expenses. You don’t necessarily need to save enough to ensure you can keep eating out twice a week or to cover other entertainment expenses. The must-pay expenses are what matter.
An emergency fund with three to six months of living expenses could sustain you if you suffer a serious medical issue, can’t work for a while, and aren’t eligible for disability benefits. Or, if you were to be deemed redundant by your employer, it could give you the money to keep making mortgage payments until you find your next job.
In other words, it could mean the difference between a brief period of financial hardship and long-term financial disaster.
How should you decide whether to save three months or six months of living expenses?
There’s a rather huge difference between saving three months of living expenses and saving six months of living expenses – so what size of an emergency fund is right for you? The answer depends on how vulnerable you are to a financial emergency.
Your emergency fund should be more substantial if:
- You’re the sole or main breadwinner
- You have an unstable job
- It would take you a long time to find a new job if you lost your current position
- You have no other money saved for home or car repairs
- You aren’t very healthy
The likelier it is that you’ll lose your sources of income or need lots of money to pay surprise expenses, the bigger your emergency fund should be.
When does a smaller emergency fund make sense?
While saving three to six months of living expenses in an emergency fund is a good rule of thumb, it takes a lot of time and financial discipline to put aside this much money. And, there is one situation where you may not want to set this big goal right away: when you have a lot of debt.
If you owe a lot of money, you still need to prioritize building up an emergency fund before paying extra toward debt. If you don’t, you can’t break the debt cycle. While extra payments could help reduce your debt balance, a single bit of bad luck would lead you to accumulate debt on your credit cards again. This creates a never-ending cycle where you don’t make progress – and there’s a big risk that you’ll give up on aggressive debt repayment.
To avoid this problem, save up a mini emergency fund, then switch to bigger debt payments. The amount of your mini emergency fund will also be determined based on your personal situation. Saving $2,000 to $3,000 is a good rule of thumb, and you should aim for a larger amount if income is uncertain or there’s reason to believe you’re at high risk of costly emergencies.
When your mini emergency fund is built up, shift focus to paying your debt – although if you spend your fund, go back to building it up again. After debt is paid down, finish saving enough so your emergency fund covers the recommended three to six months of expenses.