Your contingency fund (sometimes known as an emergency fund) is one of the foundational pieces of good personal finance. Let’s face it, stuff happens. No matter how much cash flow planning and budgeting you do, life occasionally throws you a curve.
So, how much should you put away for life’s little emergencies? A general thumb rule is to build a “starter” fund of about $2000 to $3000. Then you want to grow that to three months, six months, or even a year’s worth of living expenses. However, I’m betting you’re not a thumb, so instead of a thumb rule, I suggest running the numbers. I like dividing the numbers into three categories.
Things Break. This category tends to happen right after the warranty runs out. When your refrigerator, washer, or air conditioner dies, you’re going to replace it. You could put the replacement on your credit card, but we already know that isn’t the best option. So you need to put enough money aside for the occasional replacement. I’d pick the most expensive item and shoot for that.
Deductibles. Look at your maximum out-of-pocket costs under your health insurance plan. What is the deductible under house and car insurance policies? Save for the biggest, and if you are pessimistic like me, save for the two biggest.
Job Loss. This is the biggie. What if you lost your job? Where will your living expenses come from while you look for a new one? Multiply your living expenses by how long it would take to find a job that would replace at least that much money. Remember, this is not the time to be optimistic. You likely lost your job in a very bad economy (like this one) and there may not be a lot of openings out there.
Now, before you get all depressed over the rather big number you have to save for, remember that people generally don’t lose their jobs that often. A little more frequent, but fortunately rare, is hitting your maximum out-of-pocket costs under an insurance policy. The most likely problem you’ll run into is an appliance breaking. So start there. Once you have that amount of money saved, you can keep building upon it and grow your fund.
Now that you have an idea of how much to save, you have to actually save it somewhere. This is where your desire for safety should override your desire for growth. Think savings accounts, bank money market accounts, and money market mutual funds. The more daring among you might consider a short-term bond fund, or even some CDs when it comes to job loss savings.
So, open an account; find some money each month, and start preparing for life’s little surprises. Even if the most you can afford right now is $25 a month, it gets you closer to your goal than doing nothing at all.
Gary Silverman, CFP® is the owner of Personal Money Planning, a financial planning and investment management firm located in Wichita Falls. You may e-mail him at Gary@PersonalMoneyPlanning.com