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Sure we all know we should have some rainy-day savings, but for too many of us that’s spelled C-R-E-D-I-T C-A-R-D. Unfortunately, it’s very easy to lurch from crisis to crisis, racking up ever larger charges until the credit card bill itself becomes the emergency. Every time I see an article on how much the fund should be, it’s usually a breathtaking amount. But really, how much is enough?
The standard CFP® exam question’s correct answer is usually some variant of three months if you’re married with a working spouse, have a trust fund, or a second job; and six months if you’re single, or married with a stay at home spouse. However, I would add to that six months’ recommendation a few other considerations: if you work in an industry or place where it would require major effort or relocation to get another job; if you have any health problems; if you’re over about 45; if you have no retirement savings; or if the economy remains in the toilet for much longer. In fact, some people are starting to recommend that you look at the current unemployment rate and save the equivalent number of months—9% unemployment, 9 months’ worth of savings.
Now that your heart has skipped a beat, let me tell you that you can safely reduce that amount somewhat by a few subtractions. Let’s say your gross is $100,000. That puts you in the 28% tax bracket if you’re single. With no other deductions your tax bite is going to be around $22K. I’m sure you have other deductions, but let’s just use this as an illustration. If you don’t have any income you’re not going to be paying any taxes, so take that off your gross. So, single person, we’re down to $77,878. Now, let’s say you were putting 5% in your 401K. No job, no 401K contribution–$72,878. I’m not going to tell you to reduce your grocery estimate, because if you’re unemployed for six months you’re going to need significant chocolate. However, being terrified, you probably will decide to eat out less and maybe not replace your entire wardrobe this year—let’s take another $1,500 off the total: $71,378: your six months’ emergency fund needs to be $35,689, not the $50,000 you thought I was saying at first gulp.
A general example never works for the specific. The emergency fund goal goes up or down depending on how you live your life now. If you’re already contributing the max to a 401K or other retirement plan, if you regularly fund a Roth, dump all your quarters into a mad money jar, in short, if you’re a big saver, replacing your necessities is a smaller number. If you would need to pay child support, buy your own health insurance, or your car is about to crap out, you need to adjust upward. If you’re self-employed, it’s six months at least plus GO GET DISABILITY INSURANCE.
I generally recommend you have an emergency fund of at least three months’ expenses BEFORE you start paying more than the minimum on any credit card debt repayment program. It’s better to pay the minimum balances and fund an emergency fund rather than have no or inadequate emergency funds and send a big payoff to the card. Why? Because without an emergency stash you’ll never get out of debt—something will inevitable come up, and back it goes onto the card. Pay cash and you’ve still got the same credit card debt; no cash and the debt just revolves–no matter how much you send, new stuff keeps getting added.
Where to put this cash? You need immediate access to it, so it needs to be in a checking account, a bank savings account, or a money market fund that you can write checks on. When you do manage to build it up to six months, you might consider putting 3 months’ worth in a 3 month CD at the highest rate you can scavenge locally or through an internet bank. Just in case you might need all the money at once, make sure the CD seller would only ding you on interest, not penalties or principal loss.
Saving six months’ worth of expenses isn’t an instant achievement—if you’re just starting out, it can take you three years or more at a 10% savings rate. I’d propose that any found money also go into this account: here’s where your tax refund (which you shouldn’t be getting), your bonus check, the computer rebates you actually remembered to collect, or the $200 you got for writing an article or making a presentation should go. I’d even suggest that it’s worth some kind of second job or seasonal or short term gig to build that fund. You can blow that stuff later when you have the fund funded. Right now, it’s the best thing you can do for your future security.
