Emergency funds: How big should your money cushion be?

Basic personal finance dictates that everyone needs their own “rainy day fund” or emergency fund. I tend to refer to this as a money cushion (or safety net, basically) because it’s meant to break your fall and give you a bit of extra padding when an unexpected expense pops up, for example your car breaks down and needs a sudden repair, or you wake up one morning with a stabbing pain in your jaw and you suddenly find you need a root canal.

In those two scenarios, maybe your money cushion can be quite a modest amount, maybe one or two month’s salary – right? That should certainly cover for a sudden, quick-fix type of emergency.

But what about if you were to (nauzubillah) suddenly lose your income. Say the economy takes a downward turn (which isn’t that hypothetical right now if we’re being honest with ourselves) and your job is at risk. Or perhaps you were to have a medical situation (again, nauzubillah) and had to take a few months of unpaid leave in order to recover.

Did you know that 60% of Bruneians won’t be able to sustain their living expenses for more than two months if they lose their source of income? In fact, more than 30% said they won’t even sustain their cost of living for a month!

(Source: BT – Most Bruneians do not have emergency funds;  news article about the national financial literacy survey)

All the scenarios I mentioned above are pretty realistic, and while we never wish for them to happen to us (or anyone else), it’s definitely important to be prepared – especially financially – because these “emergencies” can take a real emotional toll and truly affect our well-being. Like I’d said at the end of this post, the things that really matter most in our lives are our families and our health. And if there is ever a time when your health or a member of your family is in jeopardy, not having enough money is the last thing you want to deal with.

Anyway, we’ll talk about how to build your emergency fund and how to prioritize your savings (into short-term savings like a holiday, medium-term savings like an emergency fund, a wedding, a house deposit or whatever, and long-term savings like your completely ungraspable future of retirement and your kids’ education and all that boring stuff) another time – first we’ll just quickly address the how much and how big question.

Most personal finance folk online will tell you 6-12 months of income.

In Brunei, Rozielawati Hj Jamil, a financial planner from BIBD has recommended 3-6 months worth of expenses.

Now, I don’t entirely agree (or disagree) with the above recommendations, and between the two I think the BIBD financial planner has the better answer.

So how big should your emergency fund be?

In my opinion, there are three key questions you need to ask yourself before you get to the answer:

1. How much do you (need to) spend per month? Your emergency fund should be based on your estimated monthly expenses not your income.

The reason is because some people’s expenses are equal and sometimes bigger than their income. For Person A, who earns $2,000 but spends $2,100 (credit card, ka-ching!) this would mean that 6 months of income would dry up in less than 6 months – and so his emergency fund would need to be > 6 months income.

Other people on the other hand, like Person B, habitually spend less than their monthly income. So if he earns $2,000 also but only spends $1,000 monthly, his income would technically stretch twice that of Person A, and maybe he wouldn’t need such a big cushion.

Estimate or better yet track your spending so you have a good idea of how much you will need per month regardless of how much your income is.

2. I would personally recommend at least six months worth (of expenses) in your emergency fund, but to be even safer try to get that number up to one year.  

The reason is that if you lost your income (job), chances are it will take longer than three months to get a new one. And having at least half a year of cushion gives you a bit more breathing time, so you don’t have to hit the OH MY GOD PANIC button and have to desperately need financial assistance (from your family, or make bad decisions about getting emergency loans, etc. with no real idea of how you’re going to pay it off) right away.

3. The more people you support, the bigger your cushion should be.

If you’re only one person, and don’t have any other dependents, then things are a little bit less unpredictable. I mean sure, your wisdom tooth could explode into excruciating pain, or you could be out of work for a bit – but at least it would only affect one person, right?

If you have a family or other people that depend on you for financial support, then the situation could easily get more unpredictable; the probability and possibility of unexpected “things” cropping up will start to multiply. And while it’s still good to estimate based on your monthly expenses (which would already include the money spent on your dependents), you’d probably sleep better at night if your cushion stretched a little wider.

 

The obvious corollary to all this is that we’re all different, we have different needs, and because of that it’s logical to conclude that every person’s emergency fund should be different; it depends. It’s up to you to assess your situation and take a good look at the risks and the likelihood that an emergency will hit. If you have a child who is asthmatic, that’s a risk to consider. If your job is on a contractual basis, then that’s a risk (because what happens if the contract is not renewed?). If your car is a little older, and has a tendency to be temperamental… Then well, write that down.

You know how insurance agencies always ask about whether you smoke, what your medical history and family background is, have you been involved in any car accidents in the past, etc. They do this in order to assess the risks involved, and the potential likelihood of something unexpected popping up.

Having an emergency fund is an important form of self-insurance. It’s fully in your control, no “commission charges” or other middle-men, and you don’t have to fill up tedious paperwork to file a claim. But at the same time, you have to exercise the responsibility to do your own risk assessment, get a good estimate of how much you would need in the event of an emergency – even write down what you think the most likely emergencies are. This’ll help you plan your money and your overall life better, and you don’t have to stress out so much at every little unexpected expense.

One final note, since this self-insurance is self-administered, do yourself a favour and exercise the responsibility of not misusing your emergency fund for something like… A new pair of shoes.

Okay?