It’s seven o’clock and you’re just leaving work. You’re tired after a long day of work and all you want to do is turn into a vegetable in front of yet another episode of Law and Order. As you walk to your car, you notice someone clipped the bumper and managed to unhinge it from the chassis. It’s scraped, a little cracked, and almost most importantly, since it is the bumped, it looks like crap. The culprit left no note. You are probably out a few hundred dollars of your deductible to get it repaired… fortunately you have an emergency fund… unfortunately, you’ll have to tap into it for this.
That situation is one of any number of reasons why emergency funds are so important. In the situation above, you are likely required by law to fix an unhinged bumper and any visit to the shop will cost you a few hundred bucks. Without an emergency fund, you might resort to a credit card or a short term loan. If you can’t pay that back, it quickly becomes a downward spiral you can’t escape. A minor expense becomes a major expense. But how much should you have saved in an emergency fund? The answer depends on who you ask! Some experts say twelve months of expenses, other will say six months, and even others say “however much you feel comfortable with.” The answer, unfortunately, is that the amount “depends” on you and your situation.
Let me go through the whole methodology before I go through the steps, that way you know where I’m going with each of these steps. For most, emergency funds “insure” someone against the loss of a job. When you lose your job, you lose your income and the emergency fund helps pay for your life as you search for a new job. Experts recommend X months of expenses in your fund for this very reason. As the idea of an emergency fund matured, people realized it would also be used to weather smaller and shorter-term issues like car and home repairs. Tapping an emergency fund is always cheaper than using a credit card or getting a loan.
The methodology I use is to determine monthly expenses, to establish a baseline, and then adjust that figure based on factors that increase or decrease my chances of needing your fund.
1. Establish Your Monthly Expenses
The first step in is to determine your monthly expenses. If you kept a budget, look at your last twelve months to determine your monthly average. Be sure to account for seasonal changes or aberrations to your budget, but don’t get too carried away pulling out “exceptions” or one-time expenses. If you don’t budget, I recommend that you try to guesstimate and then start budgeting (using any one of these five budgeting systems  will work).
Take that number, add 20%, and that will be your “monthly expense” figure. I like using 20% as a buffer but you can use 10% or use no buffer.
2. Figuring Your Multiple
Begin with a baseline of 6 months, I think that’s the bare minimum.
Next, is your skillset in high demand? Was it easy for you to find a job? Or to switch jobs? How likely is it that you will lose your job? All of these questions will help determine how many months of expenses you need to save. If your skills are in high demand or if the likelihood of job loss is low, I’d go with the minimum six months. If you are concerned you’ll lose your job or there aren’t very many openings where you are, increase it to twelve. You can never go wrong with a larger emergency fund.
What if you have no idea? Put your resume on a job hunting site like Monster.com and see how many head hunters call or email you. You can put your resume on the sites anonymously. Head hunters and employers can send you anonymous emails (where they don’t know your email address) and you can see how many responses you get. If you don’t get any, then I’d say your job isn’t in high demand at the moment. If you get a dozen or more, then I would use that as an indicator that your job is in reasonably high demand in that area. This isn’t a perfect metric but it’s the best one I’ve found.
3. Figuring Out Your Other Risks
Losing your job is probably one of the worst “emergencies” to have, because it cuts your primary income, but it’s not the only thing that can happen. Your car could slide on ice and bend an axle, you could become sick and unable to work, or you could have a tree collapse on your house. Medical, your car, and your house are the major things you should factor into your emergency fund.
For medical, I mean everyone in your family (spouse, children, pets). I would determine the probability something will happen and then buffer the emergency fund with adequate protection. It’s really difficult to figure out whether you’ll be sick, but for issues like car accidents and at-home accidents, your use deductible as a guide. I have high deductibles on everything because it keeps premiums low. To protect myself, I have a few extra dollars saved away in my emergency fund to account for that.
There are also risks that you know about but think you can put off. We recently repaired our roof, something we knew we’d have to do within five years of buying the home. We were a little caught off guard when we had to replace it three years later but a 12 month 0% financing offer and three years of “preparing” made the replacement less painful. Add a little more into your fund if you have a similar Sword of Damocles.
4. Mitigating Factors
Mitigating factors are those things that reduce your risk. The best example is that of a family with two incomes. With dual incomes, the chance of both losing their jobs is lower than one person losing their job. That’s a mitigating factor. If the two people work for the same company and in the same department, the probability is higher than if they worked in two different industries for two different companies. If you have mitigating factors, they can influence your multiple.
My wife and I work in two completely different industries. If she were to lose her job, I would still be earning enough to support our lifestyle. If I were to lose my streams of income, her salary would be able to support our lifestyle. Given that, we may not need to put as much as a year’s expenses into an emergency fund because the probability that both of us losing our income streams is very low. If only one of us worked, then we would want typically sized emergency fund.
With those four steps, I believe most people can determine how many months they really need and feel reasonably confident that it protects them. There is never a “correct” answer to this question because we can’t predict the future, just a best answer based on your situation. As long as you have at least six months and account for the risks and mitigating factors, you’ll be in better shape than simply guessing at a number. Finally, there is nothing wrong with putting more into an emergency fund because you can still earn high interest rates by putting it in an online bank  or laddering it in high yield CDs .
How many months do you save away and how did you arrive at that number?
(Photo: yourdon )