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We had some comments about the inadequacy of a $1,000 emergency fund in yesterday's guest post. Today, we go back to an old article where we give our view on how much is enough. Suffice to say, it's more than $1,000.
You can almost count on it; when you can least afford it, something unexpected throws you for a loop. Unplanned medical expenses,  a wrecked car, job loss, or a burglary can blow away even the best planned budget. With an adequate rainy day fund, you’ll have the resources to ride out the storm. But, what is the minimum amount of cash that you need to ensure you can bridge the financial gap?
Of all the things that can go wrong financially, job loss is probably the most likely problem most households might have to cope with. Medical bills can be stretched out and unplanned losses can be dealt with, but when the income stops, things can go down hill really quickly. While unemployment benefits help, they usually cover just a fraction of the lost income.
In normal times, the golden rule to go by is “for every $10,000 of salary, you need to keep one month of expenses in reserve.”
If say you make $60,000, you would need 6 months of living expenses. Assuming that your living expenses are $3,000 a month, your rainy day fund would be $18,000. If you're pulling down $100,000 and your expenses are $5,000 a month, you would need 10 months of expenses which adds up to $50,000. You might ask why the number of months of reserves increase as you climb the income ladder. Well, the underlying rationale is that when you lose a higher paying job, it usually takes longer to land the next one and you have to make allowances for that in your reserves.
It's a good rule, but it really doesn't apply well to those with lower incomes, it understates the need for funds to deal with the unexpected. At $20,000 in income and $1,200 in monthly expenses, the formula yields only $2,400 in reserve funds which would barely cover a day spent in the hospital.
In addition, in a recessionary period, there is the real possibility of being unemployed for an extended period of time. Stashing away a rainy day fund to cover at least 6 months of expenses makes sense for all income brackets. The advantage that higher income families have is that they can typically scale back their expenses in challenging times. Therefore, with a little cheap living, a family in the high income brackets can stretch what they normally spend in 10 months to cover expenses for 12 or 13 months.
The amounts listed above are for cash invested in secure and liquid instruments. While credit can be used to weather a difficult period, it shouldn’t be the primary source of bridginging the gap.
So do the calculation, and if you have less than you need, start putting it away tomorrow because the good times are never guaranteed.
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