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The Truth about Emergency Funds & Rainy Day Funds

How much do you really need to save?

Whether you realize it or not, the money in your checking or savings account that’s sitting there in case of a sudden job loss, an emergency or an unexpected expense (or just because you haven’t spent it yet), can be called an emergency fund or a rainy day fund. Although technically two different concepts, for most people, a rainy day fund is their emergency fund, especially when living paycheck to paycheck. For others, an emergency and rainy day fund are two different accounts. The major difference between these two funds is the amount and purpose of the money held within them.

A rainy day fund is used to provide coverage for unexpected expenses, such as putting new tires on your car, replacing the fridge, or taking Fluffy to the vet, so you don’t have to rack up credit card debt or take money from your paycheck to pay for them. This fund should hold between $500 and $1,500, with a maximum amount of 1 month of non-discretionary expenses.

An emergency fund, like its name implies, is used to cover mandatory expenses, aka non-discretionary expenses, which vary from person to person, that must be paid if you suddenly lose your source of income (hence the emergency!).

Non-discretionary expenses are (by definition) essential expenses, occurring monthly or annually, that are required to be paid, regardless of loss of income. These items include but are not limited to:

Day-to-Day Living Expenses

  • Rent
  • Groceries
  • Gas, Parking and Tolls
  • Auto/Home Maintenance Costs
  • Utility Bills
  • Loan Payments (Mortgage, Car Loans, Personal Loans, etc.)
  • Credit Card Payments
  • Netflix, Hulu, other subscriptions

Insurance and Health Care Costs

  • Insurance Premium Payments (Health, Homeowners/Renters, Life, Disability, Auto, etc.)
  • Insurance Deductibles/Copayments

Other Non-Discretionary Expenses

  • Alimony/Child/Parent/Dependent Support
  • Tuition and Education Expenses
  • Association Fees/Dues

A few notes:

  1.  If you pay any of these amounts annually, you’ll need to divide that amount by 12 to get the monthly cost. For expenses occurring less frequently than annually (such as copays and deductibles), estimate how much you will spend in total over a certain number of months and divide by the number of months to get the monthly cost.
  2.  For items like health insurance, which you would typically lose when you lose your job, you should research the monthly cost of a similar health insurance plan or the cost of COBRA (which your employer should be able to give you) and include that premium as your health insurance cost.
  3.  If you provide any charitable or religious contributions monthly, add those into this amount as well.

Once you have the monthly amounts of each of your non-discretionary expenses, you’ll just add them up to find the total. This is the amount you need to cover for each month of income loss, and the first step in figuring out how much should be in your emergency fund.

The next piece of the emergency fund equation is really where opinions tend to diverge. Experts say you should have anywhere from 3 to 6 months of your non-discretionary expenses in a savings account, with some even saying (since the Great Recession) 9 months. But for the average American, even 3 months seems impossible, as a recent survey showed that most individuals can’t afford a $400 emergency. Additionally, every job is different, with some providing protection from job loss because of tenure, unions, or severance pay.

So how much should you really have in your emergency fund? Although you may not like the answer, the truth is you should save as much as you are comfortable with, but at the very least cover 1 month of non-discretionary expenses, with a maximum coverage of 9 months. Anything above 9 months may be excessive and better put towards other goals. But once again, it depends on your personal situation.

No matter how much you decide to save, you should set aside the money for your emergency fund and rainy day fund in separate savings accounts (preferably online for higher rates and hidden away from view), as putting the cash in an investment account doesn’t provide easy access when you need the money quickly. These funds are not meant to be saved and then later used for a vacation you’ve always wanted; That should be a separate account.

Even if you save a fractional amount of your monthly non-discretionary expenses, you should be proud of yourself. It takes time to build these funds and most people never put any money away for emergencies, so every bit helps. Financial security takes time, understanding and hard work, so don’t be down on yourself if you don’t achieve it overnight.

Keep saving and building—your financial freedom is in the works!

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