One of the tenets of personal financial management is to keep enough cash on hand to handle emergencies that you would have to pay for out of your own pocket if/when they occur. Ideally, you don’t want to be forced to borrow on credit or use home equity to pay for short term emergencies. You also don’t want to have to interrupt your normal saving and investing because of an unforeseen incident.
There are several areas of your life that could cost you if you have a financial emergency:
Health crisis: Inadequate medical coverage could mean very large medical bills in case of a serious illness or injury.
Auto incident: I have always advised clients that they should take the largest deductible they can afford to keep their premiums low. But the corollary to that is to be sure you have enough liquid reserves to cover your out-of-pocket exposure.
Home damage or loss: The same goes for home coverage. One bad storm can cause thousands of dollars in damage, so emergency reserves are crucial to keeping your finances intact.
A good starting point for determining how much to keep in an emergency fund is to figure out your monthly expenses. Note I said expenses not “spending.” You should not include discretionary spending like entertainment, that $5 daily Starbucks, clothes, etc. You should include mortgage/rent, car payment, utilities, groceries, and insurance premiums.
So how much is enough? Three months of those expenses is the minimum you should have in your rainy day fund; six months if you want to be more conservative; and a year if there are other factors that might give you larger exposure to a short-term financial risk.
Consider your employment or source of income. Is it pretty steady, like a salaried position? Is your employer likely to have lay-offs? Are you a commissioned sales person whose income could be volatile? The more variable your income, the larger a reserve you should have. Also, do you have more than one income source? Does your spouse/partner have adequate income to cover all or part of a short term interruption of your income? If you have back-ups, that can potentially reduce the amount you need in your reserves.
Peace of mind is the biggest benefit you can gain from knowing you’ll be okay if the unforeseeable happens. Keeping enough money in reserve so that you won’t experience stress or hardship if an unexpected bill crops up is an important step in your financial security.