Is There a Correct Emergency Fund Amount? Different Ways to Calculate How Much You Should have Saved?

//Is There a Correct Emergency Fund Amount? Different Ways to Calculate How Much You Should have Saved?

Is There a Correct Emergency Fund Amount? Different Ways to Calculate How Much You Should have Saved?

Having an emergency fund is probably one of the most important things you could for your financial well being.  If there was a hierarchy of personal finance, it is likely on the bottom with owning life insurance as not to bankrupt your family if you were to premature predecease. However, there are just a ton of different opinions on just how much should be kept in cash.

What is the Wrong Amount to Have in an Emergency Fund?

Too Little

I am not sure how much of these stories I believe but there is a shocking amount of Americans without a properly funded emergency fund:

I don’t care if the real number is $400, $500 or $1,000 – if you are a working adult you should have way more than those numbers in saving.  Is it easy to save? Of course not, I am not preaching from some high horse, but it is hard to take those number seriously when:

Although linked and studied, it isn’t whether those numbers are exact or not, there is a bigger picture.  We can’t pay a $400 emergency but luckily we are covered to watch ESPN the Ocho both in and out of our house.

Too Much

There is something to be said about being too safe too.  According to the FDIC the average savings interest rate is pitiful:

With those payouts and inflation hovering between 2 and 4% depending on what source you want to believe there is an easy case that, yes, there can be too much cash in an emergency fund.  Obviously there is a difference if you are going to be using the cash in the short term, but we are just focused on how much should be in your emergency fund.

What is the Correct Amount?

I honestly do not think there is one correct answer, but rather three separate ways to look at the puzzle.

Income Based Solution to How Much of an Emergency Fund Should I Have

The first way to answer the question of determining an appropriate amount to save in an emergency fund is to take some multiple of your gross monthly income.  That number is usually 2, 3 months or 6 months.  Let’s say you have an extreme emergency like a disability where you are unable to work, this number would come in handy because, mentally, it may feel like you are still working.

The Pro is that it is simple. Take your annual salary divide it by 12 and then multiple the amount of months you want to have.  The con is that it may be wildly inaccurate with regard to need.  Maybe you have too much because you are a saver (see above) maybe you have too little because at the current time you are running a deficit.

Expense Based Solution to How Much of an Emergency Fund Should I Have

But what about those that do not spend their entire net income nevertheless their gross? For example why should I have 3 months of gross income if I am only spending 80% of my net income (i.e. 80% of the 80% after tax income)?  In those cases people may feel safer having multiple months of expenses saved.  Again, the amount of months is a personal decision.

The major pro, is that multiple months will provide for a long term disability, however, there is one major flaw.  Most people have zero clue what they spend.  If you don’t have a SOLID grasp on your necessary expenditures then coming up with a number to have saved is a fruitless exercise.  One easy way to do it would be:

  • Net Income
  • Minus some reasonable effective tax rate
  • Minus known qualified savings
  • = Monthly expenditures

It is amazing to me how many people think they spend less than they do.

Being Able to Sleep at Night – Emergency Fund

This method can be used by those that really understand their personal finances.  The amount is chosen at the amount of cash that is needed if the crap hits the fan moment.  To me, this is the most advanced of the calculations because someone really needs to know themselves and understand their personal situation.  The pro is that by its very definition it is the optimal amount allowing someone to feel safe and sleep at night.  The con, is that if not done correctly it could be disastrous.  I would not recommend this method for most people.

How Did my Family Determine the Cash Necessary for its Emergency Fund?

The Wife and I went with the “being able to sleep at night” method.  The amount is less than a few months income and expenses, but it still allows me to sleep and cover any quick housing emergency.  I have used it a few times in the past few years, but the last time was when our air conditioning unit went – I was able to offer the AC Guy cash to get a discount. The remainder of our emergency money is held in very liquid securities.

 

 

By | 2017-01-24T10:56:21+00:00 January 24th, 2017|Personal Finance|6 Comments

About the Author:

Evan is the owner of My Journey to Millions which was started to track his journey from a broke debt ridden law school graduate to building a positive balance. Need more Evan? Follow him on Twitter, Contact him or get new posts directly to your email

6 Comments

  1. ambertree January 24, 2017 at 12:11 pm - Reply

    We are in the sleepwell category, aiming for one year of expenses in cash.
    With the current interest rates, that Hurts.that being said, savings accounts will almost always loose from inflation.

    In a few years, some of my I insurance accounts start to act like savings accounts. They keep better up with inflation.

    • Evan February 15, 2017 at 1:51 pm - Reply

      You have permanent insurance too? I have a few whole life policies that act as a sort of super emergency fund if shit REALLY hits the fan

  2. Financial Panther January 24, 2017 at 7:34 pm - Reply

    I’m in the sleep well category as well when it comes to my emergency fund. I like to keep it constantly building up, so I put in a small amount even few weeks automatically. I don’t notice the money and my emergency fund stays nice and topped off.

    One good thing about basing your emergency fund off what you spend is that, even if you underestimate it, most people will still probably cut back on their spending in the event of a job loss (at least I hope they do). So even if you underestimate, you could still be fine with an estimate as to what you spend per month.

    • Evan February 15, 2017 at 1:52 pm - Reply

      I used to add money to the emergency fund but stopped in recent years. I think I may start that up again! Thank you for the reminder

  3. Brian January 26, 2017 at 11:02 am - Reply

    Once you have any amount of cash saving it helps you sleep better at night. We carried a $1k while paying off our debt and found it covered most emergencies. The size of the emergency fund is a personal decision. I do like the expenses approach for a 6 to 1 year period. Just image if you main income was gone for a period of time which I think will help you decide.

    • Evan February 15, 2017 at 2:01 pm - Reply

      Depending where you are in the world $1k may be fine, I just know any house problem I have is a multiple of that!

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