RebelCapitalist: Financial Information for the Rest of Us

In Case of an Emergency

Oct 07, 2008 | By: Mr_Blue | Comments | Permalink | Tags: personal finance, savings, emergency funds, emergency

The best time to save in case of an emergency is in good economic times. However, with our current economic situation it is best to start saving if we can. The purpose of an emergency fund is to cover expenses due to an unexpected event such job loss or an accident.

How long we can cover our living expenses in case of an emergency?

The best way to determine how long we can cover expenses in case of an emergency is by performing a simple calculation. We need to calculate our living expense coverage ratio (don’t be scared by the name):

Living Expense Coverage Ratio = Monetary Assets/Monthly Living Expenses

Monetary assets are cash, checking account balances, savings accounts, CDs, money market accounts/funds. The answer we get from the living expense coverage ratio is in terms of months. For example, if I had $7,000 in monetary assets and $3,000 in monthly living expenses ($7,000/$3,000), I would be able to cover 2.33 months of living expenses with my current funds in case of an emergency.

The rule of thumb is that we should be able to cover 3-6 months of living expenses. We should set a goal to cover 6 months of expenses. Some financial advisors would argue that this rule of thumb is dated because people have access to credit cards and home equity lines of credit to fund emergencies. However, I argue that using credit cards or home equity lines of credit only increases our interest expenses at a time when money is tight, so if at all possible try to use an emergency fund instead of debt to fund living expenses in case of an emergency. There are several objectives of an emergency fund: 1) (obviously)cover expense in case of an emergency; and 2) avoid having to liquidate long-term investments such as IRAs, pensions or 401(k)s.

How do we set up an emergency fund?

The best time to save in case of an emergency is in good times. But, if we can afford to we probably should start now. It may take a while to accumulate 6 months of living expenses. At the least, we should target 4-6 months of “housing expenses.” Housing expenses are the mortgage/rent, homeowners insurance, property taxes and utilities. We need to preserve and protect our shelter.

The emergency funds should be in a separate account such as in a savings account, checking account or a money market account. The emergency fund should be in highly liquid and highly accessible assets. We will not earn a high yields on these emergency funds but this emergency fund is not an investment it is savings for an emergency.

Godspeed and Good luck.