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Everybody with basic financial knowledge knows the importance of an emergency fund. Just look, here, here, and here. It’s really everywhere in the personal finance blogosphere. Especially with the recession still ingrained in our minds, emergency funds are a hot topic these days. More and more people are choosing to pay themselves first. However, there are a lot of opinions about how much money to have in an emergency fund. Many argue for 3-6 months worth of expenses. However, there are some financial specialists that argue for even more than that. I’ve even seen some people argue for having a year’s worth of expenses. With so much disparity out there, let’s take a look at some of the factors that should help determine the size of your emergency fund.
External Factors
This includes the things that you have little control over. Things have to do with your environment. Here are a few to consider:
- Market Conditions – You should adjust your target size of your emergency fund based on the health of the economy. For example, if you were to lose your job, how long would it take you to find another job? According to an article released by The Wall Street Journal in July of 2009, average unemployment lengths are at an all-time high of 27 weeks. This is definitely an important metric to consider.
- Family and friends support - If you were to lose your job, and were struggling to make ends meet, would you receive any support from your family or friends? I’m not taking a stance on the debate of whether you should borrow money from friends or family, but rather advocating that you know your own situation.
- Job Security – Arguably this would belong with market conditions, but i thought it was important enough to mention separately.
Internal Factors
These factors involve things that you have some control over (although not always). Here are a couple to consider:
- Monthly Expenses – Since you’ve been tracking your spending, then you should already know this number right? If not then get to it! One thing to also consider is that in the event that an emergency does happen, there are always ways to cut back on your expenses. For example, you can choose to eat out less, or cut cable. These are areas in your budget that are discretionary (compared to your rent or mortgage). It is up to you to determine how important these discretionary areas are.
- Risk Aversion – At the end of the day your emergency fund is for you, and you need to be comfortable about how much money you have saved. Personal finance is personal, and so sometimes it’s about what makes you sleep easy at night, not what makes sense mathematically.
What to do once you have your magic number
We’ve seen that it’s easy for us to fall victim to the status quo, so you will definitely want to automate this process. Set up an automatic deposit into a savings account. Set the amount as high as you can afford, keeping other liabilities and goals in mind. Personally I use ING Direct for my savings account, because they make it easy to set up multiple accounts. The goal is not to get the highest return on investment but guaranteeing that you will have the money available to you at the time of the emergency.
What’s my magic number
I’m still working towards filling up my emergency fund. My current goal is to work towards 9 months of complete expenses including my discretionary spending. I am currently about one third of the way there. What about you? What are some other things that you take into consideration when dealing with your emergency fund?
(Photo courtesy of troymason)
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