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Emergency Funds – How To Calculate What You Need

By Debt.ca on March 11, 2013 No Comments

We’ve written before about the importance of having an emergency fund, but while we’ve talked about WHY they’re important to have, we haven’t really gone into the details of how much you need to save.

Emergency Fund – A Good Beginning

Most advice about building an emergency fund says you should have between 3 and 6 months’ worth of expenses. If you’re just starting out, this is a frighteningly lofty goal.

So start small and pick a number between $500 and $1,000. $1,000 is good because it will cover you for the majority of life’s small emergencies. Once you have that, you can start figuring out what your full emergency fund should look like.

Full Emergency Fund – What Is It Covering?

Now the more complicated question. Let’s assume you’re going for the complete 6 months version. Some people think you should just take your monthly income and multiply by 6. But if you lost your job, you wouldn’t automatically have expenses equaling the exact amount you had been bringing in, right?

Option 1 – Fund The Lifestyle

Your first option is to set your 6 month target so that if you do lose your job, you can continue with your current lifestyle without any kind of financial interruption.

That means you’d continue to enjoy the entertainment you had, eating the way you had, travelling the way you had, and buying what you typically bought.

For most people this actually WOULD look like most of your salary, unless you’re also very good at saving a large portion of your income each month.

Option 2 – Only The Necessities

The other option of course is to calculate how much you need to fund your necessary expenses, while making drastic cut-backs to other areas of your life.

You’ll have to decide just how drastic to get. For example, you could move from your 2-bedroom rental to a bachelor’s apartment, and you could get rid of your expensive cell phone plan. For now let’s work on the assumption that we can trim the fat, but we want to keep your life stable enough that once the emergency has passed you don’t have to completely re-build your life.

Step 1 – Write Down All Expenses

Hopefully you have a budget already and know what these numbers are. If not, gather all your bills and calculate the monthly average of rent, utilities, food, etc.

Step 2 – Cut, Cut, Cut

Now you have to decide what you can reasonably reduce or eliminate. Spending $400 a month on eating out? You can either cut that out and have your emergency fund fully funded earlier, or you can decide to keep it and work extra hard to put an extra $2,400 into it ($400 x 6 months).

Probably the best thing to do is cut drastically now, and then once that goal is reached, contribute smaller amounts to build it up slowly to cover non-essentials like eating out.

Step 3 – Add It Up

Once you’ve made your cuts, you should have a list of your essential monthly-averaged expenses. Simply add ‘em up and multiply by 6. That will give you your goal of 6 months’ worth of savings for your emergency fund.

Now, if you lose your job (after you’ve saved this amount), you’ll be able to continue a minimal lifestyle for the full 6 months.

A Last Note About Emergency Funds

If you’ve never had a chunk of money sitting in your account before, there will be a massive desire to spend some of it. All of a sudden running out of scotch before a dinner party will be “an emergency”, worthy of using your hard-saved money for.

It’s important to understand what an emergency actually is, and to not dip into this fund for any reason other than a true emergency.

Once you’ve saved up this amount, it should be relatively easy to start saving for other things. Have a short-term savings fund for things like vacations, furniture, and car repairs. Have an even smaller one for a ‘monthly go-to-a-fancy-restaurant’ fund. Whatever you want to do and however you want to structure things is fine, as long as you aren’t using your emergency fund as a personal chequing account.

Debt.ca

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