Bad stuff happens. At some point, your car will break down. You will suffer a job loss. A loved one will get sick. And when those things happen, you’ll want to focus on the things that matter and not money. That’s why a sufficiently stocked emergency fund is part of every solid financial plan. But what is the right emergency fund size? Three months? Six months?
The truth is, it depends on what your monthly living expenses are, and how long you’d need to cover them in an emergency. The rule of thumb is you need to cover three to six months’ worth of expenses.
Not the most straight forward answer, right?
Well how about I give you a specific number… $1000. That’s what you need for what I refer to as the resiliency fund.
If you are familiar with Dave Ramsey, he would call this a “starter emergency fund“
The primary difference between the two is…
- The “starter emergency fund” evolves into your “emergency fund”
- The “resiliency fund” eventually becomes an additional safety net BEFORE you touch your emergency fund.
So what size should your resiliency fund be?
The first emergency savings you should have is a resiliency fund of $1000. Why?
Because in an emergency, $1000 gives you a moment to take a deep breath and devise a plan before doing something rash.
According to a recent survey conducted by Bankrate.com, over 60% of American’s couldn’t cover a $1000 emergency without going further into debt.
Here’s an example:
Driving to work one your morning, you puncture your tire with a nail. The mechanic recommends 2 new tires, to ensure they wear evenly—so that’ll be $500. Talk about adding insult to injury!
Depending on your situation, a scenario like this can start a domino effect in which some bills get paid and some don’t. Of course, this sends your stress levels through the roof, all while you’re trying to do the right thing; working on getting out of debt.
If you had a resiliency fund you could withdraw $500 from there, get the new tires, and replace the money at the next opportunity.
Your resiliency fund serves a very specific purpose
It’s meant to smooth out bumps in the road so you can stay on track while you pay down your debt. It’s a savings account in which you keep $1,000 that’s linked directly to your primary checking account. It allows for quick access and overdraft protection, helping you address any unexpected expenses or minor emergencies.
Here is the critical thing to remember: when you pull money from this account, replenishing it should become your top priority. Until it’s back up to normal, any extra cash flow should go there, instead of towards your debt. It’s a critical buffer that will keep unexpected expenses from becoming huge setbacks.
It allows for quick access and overdraft protection, helping you address any unexpected expenses or minor emergencies.to smooth out bumps in the road so you can stay on track while you pay down your debt. It’s a savings account in which you keep $1,000 that’s linked directly to your primary checking account.
Example: The impact of an unexpected expense on your budget
Let’s say your average monthly income and average monthly expenses look like this. Every two weeks you get paid around $2,500. But after you’ve paid your bills, expenses, and debts, you’re living paycheck to paycheck. This balancing act becomes a job in itself!
So let’s imagine that it’s about six days into the month and your car breaks down, requiring a $500 repair.
The surprise of this sudden expense creates a temporary cash-flow issue that can have a domino effect on your ability to pay other expenses. This typically results in folks having to make a late payment on cars, student loans, home mortgages or even take on additional credit card debt.
Now using that same scenario, let’s imagine you had a $1,000 resiliency fund in place.
When your car trouble arose, you would be able to dip into your resiliency fund to cover the $500, saving you the scramble to juggle expenses.
Once you addressed the temporary issue, you would then make it your top priority to replenish the fund.
This little buffer can have a huge impact as it keeps you from going into firefighting mode and provides a little breathing room to think through the problem. When you’re fighting to get out of debt, that time can mean the difference between a rash reaction and an intentional decision.
This brings us to the second type of account you’ll need…
The emergency fund
The second savings account you’ll set up will be your six-month emergency fund. This fund should be fairly big and cover a substantial emergency, like a job loss. Traditionally most articles about the basics of personal finance will say you don’t build this emergency fund out until you are fully out of debt, excluding your mortgage.
There are two reasons for this:
- 1It should cover around 6 months of expenses, which is not a trivial amount of money to save up, so you don’t want to put off getting out of debt to do that.
- 2This may sound odd, but when you’re getting out of debt, the last thing you need is six months of a financial cushion to make you complacent. You need to stay motivated. Fear can be a good motivator
So what size should your emergency fund be?
Truth is you should keep enough in there to feel secure. I keep mine sufficiently stocked to cover the full six months of living expenses. Because that’s what makes my family and I feel secure. Which is really drives the root of this. Having this additional savings set aside provides my family with additional insurance and security. And that’s the only metric that matters here.
The whole point of the fund is to provide a sense of calm that you can tap into during a crisis. How much emergency savings you need is up to you. Coming from a place of being over $100,000 in debt…I like a lot of calm and security in my life.
One thing I recommend when it comes to setting up your emergency fund is to set it up in an account that is not with the same bank that your primary checking account is. The reason for that is because it creates some natural friction in using it since it typically takes a few days to transfer funds between account not at the same bank, which helps raise the bar on what an actual “emergency” is.
So those are the types and amounts of emergency savings you need. Once you have them in place, you’ll focus less on “saving” and more on “investing”, which we’ll talk about in a future post. Just remember that your actual emergency fund size is subjective, so you need to trust your instinct. You may start with a larger one and slow right size it or vice-versa.
If you have one of these already, leave a note in the comments and tell us about a time it saved your butt!