Advice from experts and bloggers vary on the amount that one should save for their emergency fund(EF). Whose advice should you follow?
Some recommend three months of expenses while some recommend twelve months. Some recommend round numbers like $1,000 or $50,000 but it's not good enough to just build a random-X-months-emergency-fund or a random-lump-sum-emergency-fund without working out how much you REALLY need if unexpected events unfold.
Be wary of bad advice on the internet. One blogger's recommendation on the amount you need is "really whatever you are comfortable with" and "one way to establish your emergency fund is to base it on the unemployment rate"...what the...?! Just because you're "comfortable" with saving $X doesn't mean that's what you NEED in your emergency fund. And to base your EF requirements on "unemployment rate by sex, age, ethnicity, educational attainment" is insane and truly, bad advice.
Using a credit card in emergencies is fine and dandy if you're able to pay off the credit card bill at the end of the month. If you plan to use your credit card as your emergency fund and unable to pay it off at the end of the month, you will find yourself spiralling into a debt hole on top of your disastrous situation.
Events that could trigger the usage of your emergency fund:
* Job loss(if you're an employee) or loss in sales or revenue(if you're a business owner)
* Unexpected health issues such as broken legs or arms, dental problems etc
* Unexpected expenses such as your car breaks down, washing machine breaks down, your gutter is leaking etc
* Loss of tenant in your investment property, thus a shortfall in rental income before a new tenant could be found
* If you are retired and surviving on dividends, the last thing you want to do is liquidate your stock portfolio at inopportune times just because your dividend income dropped
How much should you have in your emergency fund?
If you can afford income protection insurance, then buy it! If you have a job loss, the income insurance payments will kick in and that means you can survive a lot longer if you don't need to use your EF funds immediately. Always check the fine prints before you buy income protection insurance so you know what they cover, how much they'll cover and when they'll cover you.
While having any funds stashed away for a rainy day is better than having nothing, to calculate the most ideal amount you should have in your EF is to start with the question of unemployment. If you build an emergency fund to cater for a pessimistic scenario then you won't find yourself having to make any panic decisions or having to rashly liquidate your investments in order to put food on the table and a roof over your head.
If you lost your job/main source of income, how long would it take you to find another job/main source of income?
* If it takes anything less than three months to find a new job, then you can build an EF that covers that period plus three months of expenses.
* If you think it will take you seven months to find new work, then your fund should cater for seven months plus three months extra.
That's a rough rule of thumb for a pessimistic scenario. Can you see the pitfalls with saving an emergency fund that covers six months of your expenses when you expect that it will take you eight months(for example) to find employment?
Your emergency fund needs to be large enough to cater for the period that you could be unemployed before finding a new job PLUS extra incase events don't turn out as you expect or you have unexpected expenses on top of your unexpected misfortune.
It's better to be over-prepared than under-prepared. Emergency funds essentially involves catering for the unexpected issues/problems/events and preparing for them so they become expected.
What expenses should the emergency fund cover?
Living and lifestyle expenses. All of it.
If you love your daily coffee or buying a monthly copy of Vogue or Vanity Fair, then build those expenses into your emergency fund. Build your needs and wants into your emergency fund. You don't HAVE to buy all your wants while you're unemployed, injured or whatever, but if you happen to buy a few of your wants, then it's not going to derail your emergency fund while you're unemployed.
If you're going to be unemployed, you'll have ample time on your hands and the last thing you want to do is stay home and mope all day just because you didn't build any luxuries or socialising costs into your emergency fund. On the other hand, you shouldn't be turning to your credit card to finance this just because you didn't prepare for it.
Some examples of expenses and bills that you can cater for when calculating how much you need in your EF:
* Mortgage repayments on all your properties: Principal place of residence and all your investment properties
* Utilities such as electricity, gas, water, landline, mobile, internet, cable
* Car bills such as registration/insurance/maintenance costs
* Insurances: Home and Content, Landlord and Income Protection Insurance
* Health: Medical/dental checkups
* Groceries and household necessities
* Expenses that you pay for your dependents: husband, wives, kids, anyone living in your household that is dependent on your income
* Entertainment: Dinner, movies, coffees etc
* Extracurricular activities such as dance/martial arts/music classes
* Loan repayments: If you have credit card debts/car loans/student loans etc then your emergency fund will need to cater for their repayment across your estimated period of unemployment > check to see if you can qualify for moratoriums on any of these loans and if you can, then the moment that your emergency kicks in, activate these moratoriums if possible
Track your daily expenses for a few months so that you have a good idea of how much you spend and need to set aside to build up your EF. Often times, the reality is that your actual expenses exceed what you thought you were spending.
Should you ever NEED to use your emergency fund in a real emergency, by cutting down on the luxuries and any superfluous spending that isn't a 'need' and is more of a 'want', you can survive a lot longer on your emergency fund stash. If you build your emergency fund on the basis of a temporarily stingy lifestyle then you'll have no cushion, and if you buckle under the pressure of trying to live such a basic lifestyle whilst looking for work, you'll find yourself in trouble when you splurge or treat yourself because you didn't cater for it.
How can you build your fund when you're barely surviving?
If you're in this category, then you can find ideas from reading SimpleLifeHabits article: '21 Simple Ideas to Get Cash Fast for an Emergency Fund'
I hope this guide answered your questions about emergency funds and gave you some practical ideas on what your emergency fund should cover, how much you need, when and why you need one.