“Wow! I had way too much money to tide me over when I was unemployed and had bills to pay!”
– said No One Ever
By now, you may heard that it’s best to have 3-6 months of income in your emergency fund. You know your finances better than I ever will, but it seems to me that it’s better to have 6-9 months of expenses socked away for the inevitable rainy day.
Did you see what I did there?
If not, go back and re-read it… there you go! See? In my world, income does not equal expenses when it comes to funding your emergency fund.
The Majority
For a good number of people, the words are interchangeable. It matters not whether they’re saving 6 months of income or 6 months of expenses because the monthly income and monthly outgo are the same number. And who are these good folks? Well, they are the ones who spend every penny that comes into their hot, little hands. They’re people who literally feel money burning holes in their pockets. These ladies and gentlemen will move heaven & earth to spend their money as fast as they can. It matters not if they’re earning a little or a lot – every penny is spent!
These are people who do not live below their means, for whatever reason. For this group, income is equal to expenses.
The Others
However, there is another group of people out there. They are the ones who pay themselves first. Their expenses are less than their income. They’ve managed to create some breathing room in their budget. They have funds that aren’t spent right away. For this second group of good folks, they only need to save 6-9 months of their actual expenses.
There is no point having money sitting idle in an account while waiting for an emergency when it could be sent out to work.
If you’ve been reading my ramblings for any length of time, then you know that I’m an ardent advocate of investing a good portion of your paycheque for long-term growth. This is what I mean when I say that the money not spent on your day-to-day survival should be sent out to work. When your expenses are less than your income, the difference between the two should be invested.
Allow me to be very, very clear. The money that is meant to cover your expenses during an emergency should never be invested for long-term growth. You need not run the risk that the stock market suffers its worst historical drop on the very same day that you lose your job and have to pay the mortgage. Your emergency fund needs to be sitting some place that is both boring and safe, like in a savings account at an online bank. When the emergency happens, you will need to access the funds quickly. You also need to be certain that they will be there. The volatility of the stock market offers no such certainty.
So whatever amount is needed to cover expenses should be in a boring, old savings account.
Money over and above your 6-9 month emergency stash should be sent elsewhere.
Personal Experience
For the sake of transparency, I will confess that what isn’t spent on the Care and Feeding of Blue Lobster is divided into two pots. There’s the long-term pot where I keep my retirement money. That pot is brimming with equity investments that pay me capital gains and dividends every year. Hooray! Then there’s the medium-term pot. This is where I stash the money to pay for things that will happen in the next 1-5 years. This pot pays for the un-sexy necessaries like insurance premiums and taxes. It also covers the fun stuff like vacations, concerts, and gifts.
The bottom line is that these pots are filled with the difference between my income and my expenses. In my case, my emergency fund covers 9 months of expenses. I can now use my money to fund long-term investments and medium term goals, all while knowing that my emergency fund is safely tucked away until I need it.
Why 9 months instead of the minimum of 6? That’s easy. I’ve always believed that it’s better to have more money than needed during an emergency.
A little something else to consider…
Expenses generally include debts. Take your pick – student loans, vehicle loans, mortgage, credit cards, medical, personal loans, veterinary loans, etc… If you’ve used credit, then you have debt. Chances are you’re paying off that debt each month, so your debt payments must be included in your expenses.
Debts don’t disappear just because your job has. That means your emergency fund has to be big enough to cover your debt payments should your income disappear.
But what happens to your emergency fund once your debts disappear?
The necessary minimum size gets smaller!
Excuse me, Blue Lobster? What are you saying?
Let’s say that your monthly expenses are $3500 per month. Part of that is a $1000/mth mortgage (or rent) payment and a $500/mth payment on your vehicle. For the sake of this example, your monthly expenses include $1500 in debt payments.
If you’re building a 6 month emergency fund, you need to have $21,000 set aside to cover your monthly bills in the event of an emergency.
However, once you’ve paid off your debts, then your monthly expenses are only $2000 per month. (This assumes that you don’t replace your former $1500 debt payments with new ones!)
Now, your emergency fund need only be $12,000 to cover six months of your expenses.
Will it take you less time save up an $12,000 emergency fund? Yes – yes, it will.
Getting out of debt means you don’t have to spend as much time building your emergency fund. In this example, the extra $9000 (= $21,000 – $12,000) can be invested for long-term growth that much faster. Ideally, Mystery Person learns to spend cash and doesn’t go back into debt. While Mystery Person goes to work, the $12K sits quietly in an account and the former debt payments are re-directed towards long-term investments.
Saving 6 months will take a long time!
Please go back and re-read the quote at the start of this post. No one promised that saving up an emergency fund would be a quick process. The fact that it takes a long time in no way diminishes the importance of creating one!
Start saving for your emergency fund today. Set up an automatic transfer from your paycheque to an online savings account. Do not get a debit card for this account. Once the money goes in, forget about it. This money is not to be touched unless your livelihood is threatened or gone.
Trust me when I say the following. You won’t want to be worrying about money in the middle of your emergency. Having an emergency fund to pay for things will be a comfort during an emotionally awful time.