"How much money do I need in an emergency fund?" is a question I get asked a lot. I have peers who recommend having enough money in an emergency fund to cover anywhere from 3 to 12 months of living expenses. I, however, am in a slightly different camp. I believe the amount of money one keeps in an emergency fund should be determined by looking at two separate areas: 1.) living expenses and, 2.) the amount of debt a person carries.
The Connection Between Living Expenses and Emergency Funds
I would suggest people spend a few minutes reviewing their living expenses in two ways. The first would include looking at your monthly expenses when life is running smoothly and there is money for entertainment and other non-essentials. The second would be to calculate only the bare bones monthly expenses to keep afloat financially.
The barebones monthly expenses are what to use when calculating living expenses for an emergency fund. As an example, when an airplane encounters an emergency in flight, all non-essential services are shut down and only the services critical to the plane's safety are operational. Calculating living expenses for an emergency fund should be thought of the same way. In a perfect world, 12 months of bare bones living expenses set aside in an emergency fund would be ideal. However, most of us do not live in a perfect world and in my experience, 12 months of living expenses is difficult for people to stash away. Assuming a person has little to no debt, I have found 3 months worth of living expenses is a good minimum threshold for which to aim.
Building an Emergency Fund If You Carry Debt
I have news for you. If you are carrying balances on your credit cards or have other consumer debt such as furniture loans, you may not have a full blown financial emergency, but your financial ship needs some patching. If this describes you, establishing an emergency fund should be thought of in stages. The first order of business would be to save $1,000 and sock it away in a high yield savings account. Once this is achieved, you should focus on whittling down your debt. After you have eliminated your outstanding credit card debt, then you should look to accumulate enough money to carry you through three months of basic living expenses if your primary source of income disappeared. As time passes, you can continue to add money to your emergency fund to strengthen your financial foundation.