Many people don’t have an emergency fund because when they accumulate some money, they spend it. An emergency fund should consist of 3 to 6 months worth of living expenses held in short term investments. Whether you have 3 or 6 months depends on whether you have one or two incomes. The rule of thumb is that a family living on one income should have 6 months worth of expenses. A family with two incomes may be able to get by on 3 months worth of expenses.
Disability insurance policies can also affect how much you should have in your emergency fund. Most disability policies begin to pay after 90 days, or 3 months. In this event many people think that a 3 month emergency fund is all they need. This is not true. If they lose their job, and it isn’t due to disability, the policy will not pay.
Building an emergency fund may seem like an arduous task. In all honesty, most of the difficulty is all in your head. For example:
My wife and I had our first child in January 2007. Talk about not knowing where you are going to get the money for extra expenses, we had no idea how we were going to afford childcare, and everything else from diapers to formula. We both work, and while we have an emergency fund, we didn’t want to tap into it for an ongoing expense.
The truth is that the best way to save for an emergency fund, or anything for that matter, is just to set it up automatically, and let everything else adjust. Not only did we begin paying $500+ a month for child care, I also began contributing $300 to a Roth IRA. This is $800 a month that we had no idea we could afford until we had to.
This may seem like a crude example, and yes, we did have to make some adjustments, some of them more painful than others, but I can honestly say after 14 months with my son, it is worth it. Now baby two is due in December and our daycare bills will increase to about $1,500 a month. This shouldn’t be a problem as I’ve already started saving $500 a month extra towards our emergency fund, and another $100 to bring my Roth IRA contributions to $400 a month. And yes, adjustments have been made, some more painful than others. Golf and Aikido are out because they cost money. Running and time at the park are in because they are free.