An emergency fund calculation
Question: The concern I have is whether I am determining 6-12 months worth of living expenses correctly. The range I get when attempting to account for monthly financial needs (essentials vs what we actually spend each month, unforeseen factors affecting future income, i.e. one job loss vs two, etc.) is significant. Is there a rule-of-thumb for determining safety net amount? For example, I believe I have enough saved for 5 months at our current spending level but I suspect we could stretch it for 14 months if I lost my job and we cut back significantly.
The second question: With the help of an unanticipated end-of-year payout, I believe I will have 7K remaining once I complete our safety net. I am considering applying it to the principal of the 20K in student loans that I have remaining, on which I pay 2.87% in interest. (I have maxed out my 401K and do not have any other debt.) It is likely that my husband and I will have a baby within the next 2-3 years, so I had also considered setting this money aside as additional savings. Julie, Worcester, MA
Answer: You’ve done your emergency savings homework. It isn’t surprising that you get a range, since a lot depends on a number of assumptions and known unknowns. But I think you’re on track.
There are three key parts to the emergency fund equation. The first is adding up all your monthly mandated expenses, such as the mortgage, insurance payments, car payments, and the like. These are the numbers you can’t escape. It’s your baseline.
You also need to calculate your discretionary expenses and see where you could cut back. You can’t get rid of all of them. But this is where you have the most room for financial maneuver. I imagine it’s here that you got the range of 5 months to 14 months.
Last is a guesstimate on how long it will take to find another job. The national data shows that it is taking longer than before, which is why the standard advice of 3 month to 6 months has been upped to 6 months to 12 months–or more.
For example, you say that you have 5 months savings at current spending levels. But you would cut back no matter what if you lost your job. By how much? Well, if your job skills are in high demand or your industry is growing by leaps and bounds in your area, you would cut back on spending somewhat as a precautionary measure. But you’d realistically expect to have a job relatively quickly.
On the other hand, if you’re in a declining industry or there’s a lot of competition for jobs in your area, you should be prepared to live cheaply for a year. From what you’ve told me you have the savings to pull that off, at least come close to it.
You should run a scenario where both you and your husband get laid off around the same time. That’s your worst case and you should see how long your savings last.
To help you with your calculations Bankrate.com has an emergency fund calculator.
On your second question, you can’t go wrong paying down debt or adding to savings.
My sense is that you’re a good saver. I would take the opportunity to come closer to the goal of being debt free. What if you divided the money, say, putting $2,000 into savings and $5,000 toward debt or $1,000 into savings and $6,000 to debt? This way you take a large stride toward getting rid of the student loans yet still add a bit to your savings.
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