If you’re just stopping by for the first time, this is the fifth class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by the orientation class HERE first for class orientation/overviews and HERE for more information about the website.
Class Objectives: To understand why emergency funds and cash reserves are important and how much you should have saved in each fund.
Prerequisites: PF101: Personal Finance Overview & Setting Goals and PF104: Creating a Budget & Cash Flow Statement
Handout: Ways to Save for Your Emergency Fund (PDF here)
Assignment: Emergency fund & cash reserve spreadsheet in Excel| Google Docs (previews in lecture material)
If you’ve heard it once, you’ve heard it a thousand times: “Set up an emergency fund of at least $1,000!”. Setting up an emergency fund is one of the basis principles of personal finance, such as spending less than you earn. Hopefully you already have one, but if you don’t, then I’m going to tell you for the thousand and first time: Set up an emergency fund of at least $1,000! According to numerous studies, most Americans don’t have hardly any savings at all and are just 2 paychecks away from homelessness in the event that they lose their income.
An emergency fund is so important, but I do believe that $1,000 is an absolute minimum and really not nearly enough for the vast majority of people.
If you didn’t add that to your goals and you don’t have any savings yet, go back to your goals and write it in RIGHT NOW at the top of that list.
I have two separate funds. I have an “emergency fund” for unexpected expenses such as a medical emergency or a major home repair and I have a “cash reserve fund” that would cover an unexpected job loss or a disability that would prevent my husband from working since we are currently a one-income family. Why two separate funds? It’s simply the organization fanatic in me that likes to assign numbers to everything and have specific amounts assigned to specific goals.
FIRST STEP – $1,000 in emergency fund
The very first thing you are going to do is to save $1,000 in a designated savings account for an emergency fund. I do not honestly think that $1,000 is enough in total to save for emergencies, but it’s a good start and will cover a lot of minor emergencies and keep you from de-railing on your financial plan if when you have unexpected expenses that come up while you’re working on other financial goals.
SECOND STEP – build up your emergency fund while also paying down debt
You may be familiar with Dave Ramsey’s famous baby step #2 that suggests that you pay down all your debt as the next step to creating a $1,000 emergency fund, but that could take people with even an average amount of debt (around $15,000 in 2015) a few years or more. $1,000 is simply not enough to cover a most major emergencies, especially since the majority of medical insurance operate under high deductible plans with deductibles of $2-3,000 or more. It would be devastating to work so hard to pay $3,000 down on your credit card, only to add it back in one day because you don’t have sufficient savings to cover the expense. During the second step, I suggest to allocate a portion of your money to paying additional on your debt and a portion of funds toward building up your emergency fund. My suggested total for your emergency fund is the largest of the following numbers:
- Emergency fund base amount of $1,000
- Your medical insurance deductible if you have a high-deductible plan
- Your emergency room co-pay if you have one
- Your homeowner’s insurance deductible (or renter’s insurance deductible)
- Your auto insurance deductible or the cost to replace your auto if you don’t have collision or comprehensive coverage
- The cost to replace your most expensive home appliance (water heater, furnace, air conditioner, refrigerator, etc.) if you own a home
- Other major expenses specific to your situation
THIRD STEP – save 3-6 months for your cash reserve
After consumer debt is paid off (credit cards, personal loans, etc.), the next step is to build up a cash reserve of 3-6 months of your expenses. I would estimate that this step could take most people just starting on their financial plans several years to build up after paying off debts, unless you are able to drastically reduce your expenses or increase your income. If you’ve had a significant amount of credit card debt that you’ve just paid off, that alone will free up the amounts of the monthly payment, plus the extra you’ve been paying each month to pay them off and you can direct some of this money to your cash reserve.
How Much Do You Need in Your Cash Reserve?
Experts suggest saving anywhere from 3-12 months in a cash reserve. Ultimately, you should save as much as you need to feel comfortable that you’re totally covered with any type of financial emergency. My suggestion is that you save the amount listed from Step 2 (additional emergency funds) PLUS 3 months expenses, which in total will probably be closer to 4-5 months of expenses if you want to compare my recommendation to other personal finance recommendations.
I’ve included an spreadsheet file to use to estimate your monthly expenses. This spreadsheet mimics the budget spreadsheet you set up in PF104 and I’ve highlighted the categories that you should take a special lookout that will likely change if you are experiencing a job layoff or other situation that requires you to dip into your emergency funds. In these situations, you will likely need to cut out some optional items such as entertainment expenses, eating out at restaurants, daily Starbucks, etc. Click on the spreadsheet preview below to see a larger version.
One thing that you may notice on the bottom of the spreadsheet is that I have included other spouse’s income as offsetting the amount you need to save to cover 3 months expenses. This is because the likelihood that both income earners will be laid off or disabled is quite low. In a dual-income family, most likely one spouse will be able to work. Of course, this doesn’t cover all scenarios so adjust this to include whatever you are comfortable with. A very conservative approach would be to not include the other spouse’s income.
The amount you want in your cash reserve depends on:
- The stability of your job
- Your current health status
- Whether you’re self-employed
- Whether you have short and long-term disability insurance in place to help cover expenses during a disability
- Whether you are dual-income family
- Whether you would have financial support from family in the case of an emergency
WHAT IS AN EMERGENCY?
Both of these funds should only be used in the case of a legitimate emergency. Examples of emergencies include:
- You unexpectedly lose your job
- You become disabled
- A medical emergency that requires an urgent care, emergency room, or hospital visit.
- A major home appliance breaks unexpectedly (furnace, air conditioner, hot water heater, refrigerator, etc.)
- A pipe bursts in your home
- You have a death or illness in your family and need to pay for unexpected travel costs to help family
- Someone hits your car in a parking lot and doesn’t stop, leaving you to pay your auto insurance deductible
- Your car needs a new transmission
- Your dog needs emergency veterinary care
Examples of non-emergencies that you should not use these funds for include:
- A sick child needs to go to the doctor to get some antibiotics (really parents, you need to plan for this to happen!)
- Your car registration fees come in the mail and you had forgotten that you had this extra expense due this month
- One of your car tires, which you keep driving on even though they’re bald, pops and you need a new tire ASAP (granted now it’s an emergency, but this should be part of your annual budget!)
- Your wardrobe is outdated and there’s a great sale going on right now (fashion emergency!-um, nope)
WHERE SHOULD YOU KEEP YOUR FUNDS?
Your emergency funds and cash reserve should be kept in liquid assets, such as checking or saving accounts, money market funds or short-term CD’s. Since the very definition of emergency means unexpected, you should be able to access your funds at any point that you may need them without penalty. My recommendation is that you put your emergency fund amount (as explained above) in a savings account linked to your checking account so you quickly transfer the money when you need it and put your cash reserve balance in an online money market or online savings account.
I have a Chase savings account linked to my checking account for my emergency fund. Separately, I have an online money market account with Ally Bank. They were rated the top online bank by Money magazine in 2015 and they have great service and some of the best interest rates. Their current interest rate is .85% for their money market accounts and 1% for their online savings accounts. I use bank-to-bank transfer when I wish to make a deposit from my checking account, which takes 3-4 days generally but doesn’t cost anything and I also have checks that I can use to pay expenses (limited to 6 transactions per month).
Wherever you put your emergency funds, they should be kept separate from the money you use to pay your regular bills and they should also be kept separate from your other savings funds (such as vacation savings). I personally earmark the funds in my savings account for separate things using my zero-based budget in my YNAB personal finance software. You may want to consider separate accounts if you don’t have a very, very specific way to allocate your savings amount between your goals.
Putting together an emergency fund and a cash reserve is the best way to hedge against major financial catastrophes that may come your way, but the most valuable thing that it will provide is peace of mind right now. Put away whatever amount in your emergency fund & cash reserve that will make you feel comfortable, whether that is more or less than the recommendation that I’ve provided. You will be so glad that you did!
EXAMPLE: SMITH FAMILY
The Smith family already has as part of their financial goals setting up an emergency fund and cash reserve. They calculate their emergency fund amount to be the amount of their deductible on their health insurance plan ($2,750).
Since they’ve set up their budget already they have a good idea of how much their expenses are each month and they’ve modified it to reduce expenses that they would need to reduce if they faced unemployment. Their monthly expenses averaged to about $4,000 per month and their goal is to start with a $2,750 emergency fund and a 3 month cash reserve. They plan to save the $2,750 for an emergency fund within one year and the remaining $7,200 over the following 3 years.
Your homework assignment is to calculate the amount you need for your emergency fund and make a plan for how much you will save and for how long in order to be able to meet that goal.
- IMPROVING – Estimate your monthly expenses and plan to save 4 months expenses over the next two years (monthly expenses x 4 / 24 months). Set up automatic transfers to your savings account if possible.
- INVESTED – Use your budget and calculate amounts you need to save for your emergency fund and cash reserve of 3-4 months (based on your personal situation). Make a plan to achieve these savings amounts.
- UNSTOPPABLE – Use your budget and adjust your expenses to calculate the monthly amount you need to save for your emergency fund and cash reserve. Make a plan to achieve the emergency fund within 6 months and the cash reserve of at least 3 months within 2 years.
File your emergency fund and cash reserve calculations in your Financial Plan binder under Tab 1-“Financial Goals”.
HANDOUT-WAYS TO SAVE FOR YOUR EMERGENCY FUND & CASH RESERVE
If you’re living paycheck to paycheck, you may be wondering how you can possibly save this much money. It may take some times, but here are some ways to jump-start and track your saving.