The Goal Is to Bank 3 to 6 Months of Living Expenses.
I’m writing this article while the world is amid the containment of COVID-19. In mid-February all was going well, financially speaking. Individual investment account statements had been cheery to open.
Now, as I write in mid-March, uncertainty is as high as it has been since at least the financial crisis
in 2008-2009. I’m hopeful that by the time this is published, the worst will be behind us and life will be getting back to something resembling normal. Regardless of how the future plays out and no matter when you read this, I ask that you do so in the context of mid-March 2020, through the lens of the uncertainty created by COVID-19.
And with that backdrop, there is not a better way to drive home the importance of an emergency fund. An emergency fund should be a pillar of financial planning and is meant to cover unforeseen loss of income and/or unusual or extraordinary expenses, e.g., unemployment, a new roof or medical care. The concept is as simple as it sounds: Liquid cash in a savings account that can cover necessary expenses for a predetermined amount of time. An emergency fund is not just savings though, it is cash that is specifically designated based on an estimated calculation of needs.
The needs are specific but can vary by individual. In general, needs-type expenses are those somewhat fixed in nature expenses that you require to live. Examples include but are not limited to mortgage, rent, car payments,insurance and groceries.
Figure Out What You Need
Identifying your personal emergency fund needs is relatively simple: Sum up your essential living expenses on a monthly basis and multiply that by a factor of the number of months you would like covered. The general principle is to use a factor of three to six months of your basic living expenses. For example: You spend $2,000 per month on necessary expenses and you would like to cover six months of expenses. Your emergency fund should be $12,000.
Saving three to six months of expenses may seem like a tall task. But when you know the amount your emergency fund should be, you can work backwards to come up with a monthly plan to begin funding it. Set a time frame for when you would like to have the emergency reserve fully funded. You can supplement monthly contributions with larger lump sums from a bonus or tax refund. Starting the plan is the important step. No amount is too modest!
Where to Keep Your Emergency Fund
It would be ideal to have your emergency fund segregated from the rest of your savings and checking accounts. As your emergency fund grows, so will the temptation to withdraw from it for a noncore expense, like a vacation or tires for your car that you knew you would need. I recommend using an online high yield savings account: You’re able to earn a higher interest rate than those offered at banks, while maintaining access to your savings, if needed. Avoid certificates of deposit in this case; liquidity is an important feature of an emergency fund and you do not want it locked up when you need it the most.
Transport yourself back to March 2020 and realize the value that your emergency fund will have. It can bridge finances between difficult times. It can keep you from taking on additional debt and making a future financial hole harder to climb out of. It can prevent you from selling investments to raise funds during market turmoil, which could adversely impact your longer term goals.
This article was originally published in the June/July
2020 issue of BetterInvesting Magazine.
Matt Mondoux sits on the investment committee and is an adviser at Blue Chip Partners,Inc., a privately owned, registered investment advisory firm based in Farmington Hills, Michigan. Visit www.bluechippartners.com.