No one can predict the future or the financial hardships which can result from a job loss, disability, or death. Planning for the “what ifs” of life with an emergency fund is one of the most important tools you have to help sustain your independent financial security.
How much should you have in your emergency fund? Most financial broker experts recommend having between three to six months of living expenses in a savings account. Personal finance broker expert Suze Orman advises people to have at least eight months of a safety net – the average number of months it takes to find a new job, in the case of unemployment.
Yet, Americans aren’t prepared for an unexpected emergency or hardship. More than a quarter of Americans have no emergency savings, according to an annual survey released in June 2014 by Bankrate.com. Of those who do have savings, 67 percent have less than six months’ worth of expenses, what Bankrate calls the recommended amount, and those with at least three months’ of expenses declined from 45 percent in 2013 to 40 percent in 2014.
The ability to save grows bleaker along demographic divides. African-Americans, at 40 percent, were almost twice as likely to say they had no emergency savings as whites, at 21 percent just 10 percent of those with a college degree said they didn’t have any savings, compared to 36 percent of those with a high-school education or less. Meanwhile, people ages 30-49 are the most likely of any age group to have no emergency savings.
“The key with emergency savings is safety, first. And second. And third. The way to build your savings is by spending less each month. Your goal should be to pay off your credit card bills in full at the end of each month and set aside money toward your emergency savings,” wrote Suze Orman at Oprah.com.
Wondering how much you need in your emergency fund? David Weliver, founding editor of Money Under 30, suggests calculating a more accurate picture of how much to have in emergency fund savings using four factors: minimum monthly expenses, income volatility, income commutability and existing liquid savings. There are a lot of variables the formula does not take into account, but it’s a great place to start. Also, there are a number of emergency fund calculators online to help you determine the amount of savings needed and how to begin saving.
Weliver suggests the following formula to calculate how much you need in your emergency fund: Minimum monthly expenses x Income volatility x Income commutability – Existing savings
Minimum Monthly Expenses: Determine your fixed expenses each month, such as: rent or mortgage payment; utilities; student, auto, or other loan payments; minimum credit card payments; groceries; and medical expenses.
Next, calculate the absolute minimum amount you would be able to tolerate spending on discretionary expenses like: dining out, shopping and entertainment. Be reasonable. If you suddenly find yourself unemployed, you may be able to cut back a bit, but don’t expect you’ll suddenly be able to go months without spending a nickel in a restaurant or movie theater. Somewhere between 60 percent and 80 percent of your existing discretionary spending might be reasonable.
Income Volatility: Do you have a full-time, permanent job which pays you the same salary month-after-month? If so, consider your income volatility score to be one and skip this part. If you are self-employed, work on a contract basis, or rely on bonuses and commissions for income, however, calculate a simple “income volatility score.”
If you receive bonuses or commissions, tally your income for the previous 12 months. What percentage of this figure was salary and what percentage was bonus or commissions? If bonuses and commissions comprised 10 percent or less of your annual earnings, score a one; 15 percent, score a 1.5; 23 percent, score a 2.3; etc.
If you work freelance or contract jobs, write down how much you earned each month for the previous 12 months, then choose the months in which you made the most and the least. Next, subtract your lowest month’s income from your highest and divide this number by the lowest month’s income. Add one to that number. This is your income volatility score.
For example: $7,800 (high month earnings) – $2,200 (low month earnings) / $2,200 (Low month earnings) + 1 = 2.5 (income volatility score)
Income Commutability: If you lost your job tomorrow, how long would it take you to find a new one? When you find a new job, how likely is it to pay at least as much as you now earn? Your income commutability score is how many years you have been working multiplied by 0.5 plus 0.5 for every $10,000 you earn annually over $40,000. For example, if you have worked for five years and earn $60,000, your score is 3.5. If you have worked two years and earn less than $40,000, score a one.
Existing Liquid Savings: Finally, determine whether you have any existing liquid savings which you could tap in an emergency. This cash might be in an account for a down payment or vacation. Do not include retirement accounts which contain tax penalties for early withdrawals.
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