Emergency Funds: How to Find Your Magic Number
In the wake of COVID-19, we've seen internships canceled, an 11-year Bull market come crashing down, and millions of people losing their jobs. The number of economic hardships is unprecedented, sending even those in the middle-class to food stamps and unemployment for the first time.
Though financial emergencies like this pandemic are unpredictable, their inevitability isn't. From large-scale natural disasters to unexpected medical expenses, we will all face financial emergencies at different points in our lives. Since emergencies are inevitable, in order to not be one of the millions of Americans who are $400 away from serious financial hardships, we have to be prepared. 😤
This is where an emergency fund comes in! An emergency fund is money that is "liquid" (i.e. you can access the funds within a day) that you can use to protect against financial emergencies. In this edition, we'll break down how to calculate the amount you should have in your emergency fund and some tips on how to start an emergency fund so you can have confidence that you'll be covered if 💩 hits the fan. We also have a ~template~ you can duplicate to calculate your emergency fund number.
Building the Foundation: Budgeting
Before we can talk about how to start an emergency fund, we need to figure out how much money we need to survive month-to-month. Therefore, the foundation for your emergency fund should be your budget. Your budget tells you (a) how much money is coming in (cash flow) and (b) how much money is going out (expenses). To make this more concrete, let's look at an example!
Meet Y Æ V-300 (or Kaleb for short). Kaleb, like the median American aged 25-34, makes an annual salary of $43,525 (about $3,627 a month). One way to make a quick-and-dirty budget is to track your spending for the last 3 months and taking the average. Here's Kaleb's 3-month break-down (informed by the average monthly expenses provided by Quicken) for the last 3 months (which you can check out in the "3-month expense tracking" tab here):
Though this is a fairly simplified budget, it shows some of the common expenses that most people will face (with some personal additions based on Kaleb's personality). As we can see, while many expenses are consistent (e.g. Student Loans, Netflix), others vary based on choice (e.g. Groceries vs. UberEats for meals) and situation (e.g. incidental purchases like "New Shoes"). From March-May, Kaleb spent an average of about $3200 / month.
Let's say Kaleb wants to use this as a basis for calculating their emergency fund. In a financial emergency, you're probably not going to spend as much on "non-essential" expenses (i.e. things you don't need to survive). Since "essential" can in some cases be subjective, let's assume Kaleb decides to take the most conservative view of the past 3 months, and labels the expenses accordingly (same spreadsheet as above, but in the "3-month expense tracking (categorized)" tab):
Just looking at essentials, that brought down the average monthly expenses to about $2,900 a month. There are further ways to bring this down (e.g. opting for Groceries over UberEats), but we'll assume that this is the amount that Kaleb absolutely needs to survive month-to-month. Let's see how we can use that amount to come up with Kaleb's target emergency fund amount.
Duration of Emergency
While almost anything can cause a financial emergency, they usually involve either (a) loss of income or (b) high unexpected expense.
According to TheBalanceCareers, the average unemployment duration for Americans (in August of 2019) was 22.1 weeks (about 5 months), with ~20% out for ≥27 weeks (about 6 months). Some of the factors that affect unemployment duration are the cause of unemployment (e.g. laid off vs. termination), competitiveness for a given role, and geography.
Unexpected expenses can be just about anything (life is so expensive!) MoneyCrashers lists some of the most common, including medical emergencies (up to $20K) and auto repair ($6K for broken transmission alone).
Since emergencies (and circumstances) vary widely, a good rule of thumb is to assume your emergency fund should cover loss of income*, which can last up to 6 months before you find new employment (though this could extend further based on economic conditions). Since Kaleb wants to be conservative, they assume it'll take the full 6 months to find a job if they were to lose their current one.
* Note: Typically, financial experts recommend having anywhere from 3-6 months of expenses stashed away in an emergency fund. This will usually be able to cover most unexpected expenses. If you want to separate this out, having multiple emergency funds is an option.
Calculating the Magic Number
Now that we know that we want to be prepared for 6 months without income, we can calculate our target emergency fund amount by taking our essential monthly expenses and multiplying by 6:
That's it! Come job loss or most unexpected expenses, with $17,400 saved up, Kaleb won't have to take out any extra loans to weather the storm. Now the question comes: how should Kaleb get started saving for their emergency fund?
Building an Emergency Fund: First Steps
$17,400 is no small amount, but remember that even having $1000 will put you in a better spot than 41% of Americans. Starting to save for your emergency fund as soon as possible is key!
Start Small: on average for March-May, Kaleb had about $400 leftover after each month in "disposable income" (YOLO money). Committing leftover income at the end of each month to your emergency fund is a great first step. In Kaleb's case, they can get to >$1000 in 3 months.
Minimize Expenses While Saving: though you're not currently in an emergency, you can still make a conscious effort to cut back on non-essential spending while saving for your emergency fund so you can boost the amount of disposable income you can save at the end of each month. Focusing just on essential expenses, Kaleb can save an average of about $750 a month, which can get up to >$2000 in 3 months. Check out this MoneyStory for inspiration on how to efficiently cut costs.
Utilize a High-Yield Savings Account: as we've seen when we talked about compound interest, even a fraction of a percent can make a big difference. Opting for the ~1.8% APY of a typical HYSA is essentially saying yes to free money. 💸
In future editions, we'll talk about how to prioritize emergency fund savings along with your retirement savings, student loan payments, and other savings. We'll also show you ways to save more than just your disposable income so that you can get that peace of mind faster 🌈
Hopefully, this post (and the linked spreadsheets) serve as a guide to start planning out your emergency fund. The best steps to take at this point are:
Calculate Monthly Expenses: Use our template and track your spending like Kaleb did, and make sure to add in every single item so you get the full picture. You can even track more than 3 months if you want a more accurate estimate. If you expect your expenses to go up significantly in the near future (e.g. moving to a new location), consider factoring those in (e.g. average cost of living in your intended location). Check out our article on budgeting for more details on budgeting.
Calculate Disposable Income: if you're currently employed, then you can calculate disposable income just like Kaleb (i.e. any money left over after expenses). However, if you're not yet employed, you can estimate your annual income by taking either (a) expected monthly income (if you have an offer) or (b) taking the average annual income for your intended profession (resources like GlassDoor and U.S. Bureau of Labor Statistics are great places to get income stats).
Start Saving: open an HYSA (or regular savings), and set auto-deposit for an amount that you're comfortable depositing consistently for the next few months. This sets the system in motion for achieving your target emergency fund amount. Start small (e.g. 1% of your target), and adjust as you go. The most important thing is to get started early!
Emergency funds have always been an important step to financial independence, but in these difficult times, being prepared for the worst has never seemed so urgent. Though we can't always know what will happen in the future, emergency funds give us the peace of mind to meet life's financial challenges as they come. This quote by Benjamin Franklin sums it up best:
By failing to prepare, you are preparing to fail.
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Disclaimer: The content on Young, Not Broke is for informational and educational purposes only and should not be construed as professional financial advice. Should you need such advice, consult a licensed financial or tax advisor.