By Peter Mastrantuono
While there is broad agreement that having an emergency fund is an essential building block of financial security, opinions on the amount you should maintain in an emergency fund are a bit more varied.
Some financial experts suggest an emergency fund of nine to 12 months of living expenses, while others recommend as little as three to six months. The most appropriate level for an emergency fund may center more on your specific circumstances than on any one-size-fits-all formula.
Factors to Help Decide Your Emergency Fund Level
The most important function of an emergency fund is to meet your everyday living expenses should you become unemployed for an extended period of time. Accordingly, when calculating how much you should place into your emergency fund, you need to decide two things: what are the expenses that I need to meet every month? And, how long would it take me to find a new job?
This will be different for everyone, depending on the nature of your expenses and the marketability of your job skills.
The first step is to calculate your monthly expenses related to spending and financial responsibilities that can’t be deferred, such as your rent or mortgage, food, utilities, phone and debt servicing. For parents, childcare expenses such as clothing, diapers and preschool costs, are additional considerations.
One often overlooked expense is health insurance premiums. Typically, when an employee is separated from service, he or she is provided the option of continuing health insurance coverage under COBRA provisions. Maintaining this health insurance coverage is important, but comes at a steep cost usually paid by the individual, which is why an emergency fund should incorporate this expense.
The second step is to determine how many months of expenses should be covered by your emergency fund. If you are in an entry-level job, you may believe that finding a new job will not take very long. Accordingly, you may feel comfortable an emergency fund equal to as little as three to four months of living expenses. On the other hand, if you have a unique skill set relevant to only a handful of employers, then it may take longer to find a new job, thus warranting a larger emergency fund of nine to 12 months.
As a general rule, the higher the income, the longer it takes to find a new job.
Managing Your Emergency Fund
The emergency fund is not only for periods of unemployment; it can be used to meet unexpected, large bills, e.g., medical expenses or car repairs. Since the need to use these funds can arise at any moment, the funds should be held in highly liquid savings that are not subject to fluctuations in value or withdrawal penalties. In other words, keep your emergency fund in a bank deposit or money market account, not in the stock market or a five-year certificate of deposit.
Your emergency fund should always remain fully funded. Should you tap it for an unexpected bill, be sure to replenish your emergency fund in the subsequent months.
This decision can be somewhat emotional, and it can be easy to underestimate the right amount. Your financial advisor can help you with calculating the emergency fund that’s right for you.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.
