It is exciting when a baby takes its first step! People gather around and mom or dad or grandpa or grandma records the event with a video. Even years later the viewing of that video brings smiles and sometimes tears. Your first foray into the financial world is not likely to be recorded or newsworthy, even to relatives, but it is one of the most important financial steps you can take—create an emergency fund.
What is an Emergency Fund?
The foundation of any financial portfolio is an emergency fund. What is an emergency fund? It is money set aside for the unknown surprise. According to a 2018 study by the Federal Reserve, 40% of U.S. households would struggle to pay for a $400 unexpected expense.[i] During the COVID-19 pandemic, an emergency fund would have kept many people from worry and stress, or at least eased their anxiety. The amount you choose to set aside for emergencies depends on what other resources you have and how quickly you could sell them to create cash.
How do you know how much to set aside for emergencies? The rule of thumb is three to six months of base living expenses: costs that must be met each month to have a place to live, food to eat, and a way to get to work. The emergency fund does not include money for eating out, clothing, entertainment, or vacations which are extra or discretionary expenses.
What are Base Expenses?
What is a base living expense? Base expenses are sometimes called non-discretionary or fixed expenses. They must be paid every month: mortgage/rent, utilities (electricity, gas, water, sewer), communication (TV, internet, phone), car loan or other loans, insurance, etc. Do you have a list? If not, make a list now of the expenses you must cover each month. Then, although they are variable from month to month, add an average of what you typically spend for groceries and transportation. You must eat and get to work! Also, include those items unique to you and your household, such as prescription and medical expenses, which recur and are essential.
What is a realistic amount for you and your household? Every family will be different. You may be single, married, have no children, or have many children. If your children are young groceries may not be as big a part of your monthly expenses as when they are teenagers. When you have a baby and need formula and diapers your base expenses will increase. If you work from home the transportation portion of your expenses will likely be lower than someone who commutes.
You may live in an area where the cost of living is very high. Base expenses for someone who lives in the Midwest are likely to be lower than someone living in San Francisco or New York City. Does someone in your household have critical medical needs? Are there others outside of your immediate household that depend on you for financial support? All these factors will affect the size of your emergency fund.
Sample Emergency Fund Computation
Here is an example emergency fund computation for an individual who lives alone, has a mortgage, a car loan, and drives to work (monthly expenses):
Mortgage, Taxes, & Insurance $1,000
Groceries and Household Products $675
Car Loan $445
The total monthly base expense for the above household is $2,725. Therefore, an appropriate emergency fund would be between $8,175 and $16,350. Does that seem like a lot? Believe me, when you need those funds, they will go fast!
Of course, you may have other resources that you can use in an emergency. You may plan to take money from your investments, for example. Be mindful that you may have to sell securities at a loss or, on the other hand if there is a gain, pay taxes on your profit. If your investments are in an IRA, the entire amount you withdraw may be taxable and there might even be a penalty if you are under age 59 1/2. Another option is to take some equity out of your home either through a refinance or a home equity loan. Those are not quick options, however, if you need money fast. As a last resort, some company retirement plans allow loans. That is an expensive option, however, as most who borrow never replace those funds and, although it is your money, you must pay interest.
Where to Park the Money
Safe, liquid accounts are good places for emergency funds. Money market accounts or saving accounts are appropriate. Emergency funds should not be invested in the stock or bond markets. You do not know when an emergency may arise, and you want to be able to get to that money quickly and easily, without the possibility of loss.
You may be the kind of person who chooses to go without an emergency fund. That is a risk, however, and it should be a conscious decision. Without a backup plan you are vulnerable and recovery could be slow. If you can set aside enough to handle a $400 unexpected expense, mentioned previously, it is a start.
If you are a beginning investor or if you have started investing but want to know if you are on the right track, check out my book: How to Dress a Naked Portfolio: A Tailored Introduction to Investing for Women. It is full of understandable financial information, including more examples of appropriate emergency funds, and it is packed with helpful resources.
Your First Financial Step
Although your friends may not celebrate your financial savvy when you establish an emergency fund, you will not regret it and it may make you less anxious about your financial future.
~Beverly J Bowers, CFP®