An emergency fund is to a financial plan what health insurance is to your body. No one wants to risk not having health insurance. Yet almost 60% of Americans have little to no money set aside for emergencies. That’s a huge risk with inevitable financial consequences.
Most people understand the concept of an emergency fund, but they misunderstand how it is to be used and how much they need to set aside. I'd like to offer a little more clarity on what this fund is really meant to do. My hope is, you'll not only make it a priority to build an emergency fund but more importantly, to protect it from being drained frivolously.
What is an emergency fund?
Simply put, an emergency fund is a savings account that will ensure you will weather any financial emergency you might face in the short-term. By short-term I mean between 3 and 12 months.
See chart below for a few examples of what constitutes an emergency and what does not.
An emergency fund is an extension of a household budget. It is designed to provide for larger than expected expenses that are already funded through your budget. It is, in essence, the thing that keeps your budget safe and working as it should. Without an emergency fund, the budget is in constant danger of being destroyed.
Consider these financial scenarios:
- You budget $120 monthly for medical expenses. An unexpected emergency room visit costs $375 leaving you $255 short.
- You budget $75 monthly for car repairs. Over the past 4 months, $300 has accumulated. An unexpected repair costs you $795, leaving you $495 short.
- You budget $100 monthly for home repairs. Your water heater needs replacing at a cost of $1,200. You’ve accumulated $600 but you’re still $600 short.
Notice: the budget is already allocating for these expenses monthly, but the amounts currently available are not enough to fully cover these expenses.
That’s where the emergency fund comes in to help the budget stay on track. It funds the normal [budgeted] expenses that are higher than expected plus any abnormal [unbudgeted] expenses, which thankfully aren’t that many.
Most of the expenses we have in our life should be planned for and included in our budget. The rare ones, such as unexpected travel for a sick family member, can be covered by a well-funded emergency fund.
Of course, you can’t just take money out of your emergency fund indefinitely. The budget must include an Emergency Fund category with a specific monthly amount being designated to replenish the fund or increase it until you have enough.
How much is enough in an emergency fund?
Financial experts recommend an amount equal to 3 to 6 months of your monthly ‘bare-bones’ budget. Bare-bones covers only essential expenses such as food, shelter, transportation, and basic clothing. This is a good guideline meant to provide replacement income during a job loss. However, to set a more accurate amount for an emergency fund, you need to consider two other factors:
- The number of income earners in your household. Two incomes create more stability and security, requiring less in an emergency fund because there's a lower chance both jobs would be lost at the same time. The opposite is true when there's only one income, requiring a larger emergency fund.
- The type of income earned in your household. Hourly/salary income is more stable than the self-employed or business income. The fluctuation in self-employed and business income requires a more robust emergency fund then the hourly/salary income.
Emergency Fund Guidelines
Salary / hourly employees income
Salary or hourly employees have a more stable income, which means they can plan and manage their monthly expenses. A suggested emergency fund for this group is:
- 3 to 6 months of a bare-bones budget amount.
- 3 months for a 2-income household. (Chance of both income earners losing a job at the same time is low).
- 6 months for a 1-income household.
Self-employed or commission income
Self-employed or commission/sales incomes fluctuate. This can make managing a budget from month to month more challenging. In such situation, it's best to have a larger amount saved since this kind of income takes longer to replace. A suggested emergency fund for this group is:
- 6 to 12 months of a bare-bones budget amount.
- 6 months for a 2-income household.
- 12 months for a 1-income household.
Business owners Income
Business owners are similar to self-employed or commission based income earners. The big difference is, should the business fail or struggle to make a profit, the owner is committed to the end. The process of making the business profitable or closing it down can take months. That's why I recommend the following for this group:
- 12 to 24 months of a bare-bones budget amount.
- 12 months for a 2-income household.
- 24 months for a 1-income household.
A great way to create stability in income for the self-employed and business owner is to open a "Steady Income Saving Account."
When the monthly income is greater than the budget requires, the extra is deposited in this account. When the income dips below the budget amount, funds can be taken from this account to make up for the shortage.
An emergency fund has three main functions:
To provide for normal [budgeted] expenses that are higher than expected.
To provide for abnormal expenses when they occur.
- To replace lost income to operate a bare-bones budget while income is reestablished.
Don't have a budget? Create one with my free budgeting course.
How many months of bare-bones budget do you have set aside?