Emergency funds 101

One of the most common pieces of advice from personal finance experts is that everyone should have an emergency fund. But why is an emergency fund so important and how much money do you need to have in it?

Why you need one

Why does every single personal finance guru that appears on TV or in print tell us that we should have an emergency fund? They know that life sometimes throws us a curveball – an unexpected job loss or a major illness could be around the corner. When those events happen, an emergency fund can serve as a financial safety net, helping to pay ongoing expenses so that a job loss or a health crisis doesn’t cause you to lose your car or home before you get back on your feet.

How much to save

Recommendations for how big your emergency fund should be tend to vary somewhat depending on which advisor you consult. In researching this article, I found a couple of experts who recommended saving three months of living expenses, and one who recommended saving eight months. The majority, however, recommend an emergency fund that will cover six months of living expenses. Why six months? That’s about how long it takes most people who are laid off to land their next job, and will cover the out-of-pocket expenses for most people facing a major illness (provided that they have medical insurance).

For most of us, a goal of saving six months of expenses means only six months of essential expenses – the things that are not at all optional, like housing, transportation, taxes, debt obligations and food. If ill or laid off, we’d make the decision to cut back on entertainment, eating out, clothing purchases and other discretionary expenses. But if you know that even a job loss will not stop you from going out with your friends on Saturday night, then you need to save a higher amount than those who will go into uber-frugal mode as soon as they get a pink slip.