This article will discuss something that everyone must have – an Emergency Savings Fund (ESF). Without an Emergency Savings Fund your personal financial independence and your path to FIRE can be derailed by unforeseen circumstances. First, we’ll cover why having an ESF is critical, then we’ll cover how you should determine the minimum and ideal sizes for your ESF, and we’ll end with a brief summary reviewing your first steps to take.
What is an Emergency Savings Fund?
Quite simply, it is a relatively easy to get to sum of money that you don’t touch unless something unexpected comes up. This money should ideally be in a savings or checking account, or possibly a CD or MMA fund as long as there is no waiting period or withdrawal penalty. Ideally it should be accruing interest.
Why having an ESF is critical
If you’ve never read Reddit’s Personal Finance section, you should. It is filled with people both giving and receiving financial advice, and much of it is very solid advice. However, I want you to read it because it is filled with stories of people who are in dire financial straits, getting buried in credit card debt, and who are overwhelmed financially. One of the most common reasons we see for this is that people don’t have an Emergency Savings Fund.
ESFs are critical because they are there to cover expenses when you need them the most. Examples of situations that highlight why you need an ESF include:
- Your car gets totaled and you have to rent one for a week and then buy one shortly thereafter.
- You break a leg, get diagnosed with cancer, or need emergency dental care, which can mean big bills and missed work.
- You unexpectedly lose your job and find yourself staring at 2-3 months with no income.
- Your roommate kicks you out and you need an apartment, which means first and last months’ rents plus a security deposit.
These are just a few of the types of situations where if you don’t have an ESF you will find yourself racking up credit card debt, making emergency withdrawals from your retirement, or going to pay day lenders. Your ESF is your own personal finance safety net… you will hopefully never need it, but you need to make sure it is there if a true emergency pops up.
Also, there is a rule for ESFs: Never use your ESF for non-emergency spending needs.
The name Emergency Spending Fund should imply that, but just to make it explicit, never ever touch this fund except in a real crisis. No dipping in for a vacation, no quick little withdrawal to pay for that awesome set of new golf clubs, and no using it for routine spending. It is meant to be there to help you when you are at your financially most vulnerable.
How big should my ESF be?
“Okay, okay. I get it,” you say. Good. So now you’re probably asking yourself, “How big should my ESF be?” Well, size matters! Your ESF needs to be scaled to the size of your spending and/or income. It can also depend on if your income is highly variable.
For most people an ESF that is 3 to 6 times your current monthly spending is ideal. This means if you spend $3,000 per month you should strive to have $9,000 to $18,000 in your ESF. If your spending is quite variable over the course of a year I would advise switching from a spending based model to an income based model where you try to have 3 to 6 times your take home pay in your ESF. So, if you bring home $4500/month then you should try to have between $13,500 and $27,000 tucked away. For people who do contract work or who work in industries where there is a lot of seasonality you may want to have an emergency fund that covers 9-12 months of expenses incase you miss your normal working window (example of this – a fishing boat crewman who only works in the summers… if he were to break a leg and couldn’t work during the summer he might go 12 months between paychecks).
- 3-6 times your monthly expenses, if your budget is relatively predictable.
- 3-6 times your monthly take home pay, if your budget is less predictable.
- 9-12 times your monthly take home pay, if your income is unpredictable, variable or seasonal
There are times when you can and should deviate from this. If, for example, you are paying down high-interest (more than 10% APR) debts, like credit card debt or pay day loan debt, you can have a smaller ESF until you finish paying it off. As little as $1000-2000 dollars can make a big difference in emergency situations.
For younger people, such as college kids I often recommend having enough to get you through the semester or school year. This will often be impossible without parental help, but in case of a family tragedy it will allow you to not become homeless while trying to sort out their estate.
Your ESF should be a bank account that will help you cover your costs in case of an emergency. It should be money that you hope to never touch but have for a piece of mind. You need to revisit your ESF every year and make sure that it still meets the criteria laid out above, and potentially top it off. This money should not be invested in stocks or bonds, but instead in secure and stable accounts like checking, savings, CD, or MMA accounts.
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