Podcast: Play in new window
Do you know how much you should have in an Emergency Fund? Dave Ramsey recommends having a 3 to 6 month worth of liquid savings in case the unthinkable were to happen. Serious illness, sudden loss of income, or expensive unpredictable events can take anyone by surprise. Having thousands of dollars in savings could convert a horrible tragedy into the equivalent of a “bad hair day”.
Emergency Fund Expenses, not Operating Capital
We budget more than $6,000 every month. To me, that’s a lot of money! But if you could see where it all goes then you would understand. Some of our budgeted money goes towards car replacement and our daughter’s first car/college/wedding (in that order please). We’ve also committed to give extra to our church for a new building campaign.
If we were to keep 3-6 months worth of “operating capital” in the bank it would be equal to $20,000 – $40,000. There is nothing wrong with saving that much money except the opportunity cost of the excess cash that probably isn’t necessary for an emergency fund. Also, keeping too much money in a low interest-bearing savings account loses purchasing power as the value decreases due to inflation. This is the main reason why an emergency fund is factored only on needs, not lifestyle or average monthly income.
What emergency funds are for
While the Stewart household operates on more than $6,000 a month, it’s not what our emergency fund is based on. Take away some of the “niceties” and pleasures of life and a typical month’s needs turns into approximately $3,800. I use the word “approximately” because we can’t predict the actual number. Emergencies of all kinds come in many shapes and sizes:
- An injury increases medical expenses but does not lower other monthly expenses like groceries or electricity
- A job loss decreases a tithe and will increase job-hunt related expenses like gasoline and copies of your resume’ at Office Depot
- Replacing a wrecked car will deplete an emergency fund but won’t change normal monthly operating expenses
Having cash at-the-ready makes all of these situations much easier to handle and I sleep better because I know it’s there.
What is included in calculating Emergency Funds
For us to estimate the correct amount needed in an emergency situation, such as me or my wife losing our day-job, I have to cut out all the “niceties” like saving for my daughter’s future or my Roth IRA. I would have to drastically slash things like the entertainment and clothing budget categories and would probably drop our cable package down to internet-only. The idea is to get expenses down to make emergency funds last as long as possible.
Three months of our operating capital comes out to be more than $20,000 and six months is more than $40,000! However, taking out all the fluff makes our true need for emergency fund to be $11,000 – $23,000. That’s much better!
Include these necessities when calculating 3-6 months expenses
- Shelter (rent or mortgage)
- Utilities (heat and lights)
- Food (like groceries, not eating out)
- Transportation (gasoline and car payment)
- Insurance (car, health, life)
If you take a look at your budget then you can find some things to cut now. For example: I would love to get rid of our cable now but my wife won’t let me.
If you don’t have a budget then visit http://MoneyPlanSOS.com/5
to learn how to create the Absolute Simplest Budget That Works.
Emergencies are better without debt
It should come as no surprise that a job loss or sudden expense isn’t as tragic when you don’t have to debt payments to service.
- An American couple that pays cash for their cars or pays them off will reduce their Emergency Fund need by as much as $1,100 a month (based on an average car payment of $550 according to the 2013 Car Affordability Study)
- Eliminate credit card debt from your life and you could increase monthly cash flow $632 (average household credit card debt $15,700)
- A quick search on Twitter revealed Tweeps are paying between $250 – $800 in student loan payments
If this is you then you are strangling your checkbook’s cash flow with over $2,000 in debt payments every single month. OUCH!
Note: I don’t recommend having a fully-funded emergency fund when paying off non-mortgage debt. Save $1,000 for the little bumps in the road so you can attack your debt quickly, then save up the rest after the last debt is gone!
Using an emergency fund for a non-emergency?
In Dave Ramsey’s world, this sounds like blasphemy! Don’t touch an emergency fund for anything but emergencies! I agree completely! It would be irresponsible of me to take my family’s emergency fund down to less than 3-6 months of expenses.
What if I told you there’s a way to take money out of your emergency fund and pay off your house without breaking the rules? Here is how we will dip into our 3-6 month emergency fund to pay off the house without leaving ourselves with less than 3-6 months of expenses in the account:
My wife and I have less than 3 years left on our mortgage. If our current emergency fund calculation is $23,000 for 6 months with a house payment then what would it need to be when the mortgage has been paid off? The answer: $16,000.
If our emergency fund needs to be $16,000 without a house payment but we have $23,000 saved and $7,000 left on our mortgage then why not knock it out now?
It sounds like a trick but it’s legit
We have to re-evaluate our emergency fund every year anyway because of changes in household expenses and family needs. This way we get to PAY OFF THE HOUSE SOONER and not put our family in any additional risk. We get to be 100% debt free with a fully funded emergency fund by paying attention and we will no longer be paying interest.
Here is a question for you: How much should you have in an Emergency Fund?
Please leave your comments and suggestions for in the comments below.