Can you cover the cost of a new refrigerator if yours were to break tomorrow? What’s your plan if the engine in your car goes up in smoke on the commute to work tomorrow? Are you going to end up with a giant credit card bill that you won’t be able to pay off the next month? Will you be stuck eating ramen noodles and mac ‘n cheese like your college days?
I talk a lot about saving for retirement and investing for the long-term on this site, but one of the most important aspects of our financial lives is our short-term savings.
Short-term savings is more commonly referred to as an “emergency fund” but the truth is, your short-term savings is much more than just an emergency fund. It includes everyday savings goals such as planning a vacation, or saving up for that new 72″ TV!
How much short-term savings do I need?
The first step to determining how much you should stash away for the short-term is to calculate what your monthly expenses are. If you use a service like Mint.com or Personal Capital (as I highly recommend that you do) to track your finances, your monthly spend will be just a click away. Whatever you use to track your spending, take a sampling of a few months worth of spending to get an average of what you usually spend per month. (I’ve been using Mint forever so I usually take 12-18 months worth of spending to calculate.)
Another thing I like to do is to add in an extra $1-200 to this number just to give myself a little extra buffer in my calculations.
Once you have your average monthly spending, consider a major life setback (job loss, major injury etc…) and determine how many months worth of living expenses you think you should be able to cover if that event should occur. Now multiply your monthly spending number by the number of months you want to keep on hand (typically 3-6) and viola! You have the amount of money you should be keeping as your emergency fund. Keep your emergency fund in a liquid account. Someplace like a savings or money market account. Don’t even think about investing this money in the stock market!
Note: 3-6 months is the typical generic advice for this number, I keep 3 months because I’m a bit of a gambler. My girlfriend keeps more than 12 months because she’s a bit of a worrier. Only you can determine exactly what number you’re comfortable with.
Looking Beyond Emergencies
Your emergency fund is only the base of your short-term savings. The next step is to take a look out into the near future. Are you planning to remodel your kitchen? Taking a trip to Europe? Replacing your beater of a car?
Whatever the big expense you have planned is, estimate how much it will cost and approximately when it will occur.
If you don’t have the money saved for this event yet, figure out how much you need to stash away each month to hit your goal on time and automate it. Set up a recurring transfer each month so that you treat this savings goal like any other bill you have to pay (after you have enough put away in your emergency fund of course!)
Again, this is money you’ll need access to in the near-term. So the stock market is out of the question. Most likely this should also be kept in a high-yield savings account or money market account. But if your savings goal is a little further out, say 2-4 years. You can try to get a little more bang for your buck by using a less liquid type of account. Such as a short-term CD or a P2P lending account.
Make it a Habit!
I actually have two savings accounts. One for my emergency fund which hopefully I’ll never have to touch, and another that acts as a place for my short-term savings goals and as a feeder for my other investment accounts.
You don’t necessarily need two accounts, but you do need to make your saving a habit. I’ve mentioned several times how big a fan I am of automating the whole process. It takes the temptation to stray off course completely out of the equation.
Once you have your emergency fund funded and are saving towards your other short-term savings goals you can start thinking about funneling some money into the stock market. The stock market is a volatile place and you shouldn’t put any money you need in the near-term at risk by investing it in the markets.
What are your short-term savings goals? How many months of expenses do you keep in an emergency fund?
I don’t really have an emergency fund, which is bad, I know, but prefer to take the opposite approach and invest all I can. If things go wrong I can charge a credit card and generally by the time I have to pay it next month, I have enough money to cover the emergency. If not, I could sell my investments, maybe at a loss, maybe not. Emergency funds are just free money sitting there and I’d rather try to make the money work a bit.
That’s a risky strategy. It may work for you, but I think the average person would have terrible luck with it
I don’t like having money just sit around either, that’s why I try to keep the smallest amount I’d be comfortable falling back on if I lost my job in cash.
Great article and a good practice to have emergency cash on hand for the unexpected events in life. I’m cautious so I like to have six months expenses in my “emergency” account. Like you I have another account that I label “freedom” and from there I fund other goals.
I just started the 2nd account a few months ago and I love it. I like the money being segregated so I don’t have to worry about my emergency fund taking a hit.
I don’t have an emergency fund and it is good. Now, I do realise that this is a bit controversial but I am with Adrian that the only emergency is having such fund. First, our monthly cash flow is more than enough to cover small emergencies (like dish washer breaking and stuff). If a bigger emergency comes (like loss of job) I am to get redundancy pay. And last, I would rather invest than keep loads of ‘dead’ money not doing anything.
Reading this, I sound like a really arogant gambler
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I get that some people can pull this off, but for your average person I think it would be disaster. I could cover most small expenses with my cash flow, but if I lost my job I would be screwed without anything to fall back on, even with whatever severence/unemployment pay I would get.
Great tips! It is very important to have an emergency fund. A shockingly low number of Americans actually have any sort of cash on hand.
My emergency fund goal is 1 years worth of expenses. That will cover the worst case scenario of me being laid off and struggling to find a new job for a year. It will also cover the second worst case scenario of my car dying and needing to be replaced.
I do feel bad about having this much dead capital laying around. But I do like the security it provides.
I don’t like to think of it as “dead” capital. We can’t have every dollar to our name tied up in various investments. Having a cash buffer allows our invested money to stay invested when life gets in the way.
I agree Jay, and having been through an unexpected job layoff (for our one-income family), I can say an emergency fund, for most families, is an absolute necessity. One piece of advice for those on tight budgets, just start. Put away something, even if it’s only $5 a paycheck. Every little bit helps.
I’ve been doing the $1000 starter emergency fund, but I’ve found that it really isn’t enough for most emergencies. After we move, I want to build up at least $3k before going back to concentrating on paying off my debts.
From there, I’m thinking that a proper fund for us should be a month’s motel stay plus a month’s rent in case we ever find ourselves in a situation like this where we are paying for two places and unable to stay in either of them. I’d also add the $4000 deductible for our health plan and two grand to buy a new used car in case our current one explodes. All in all, I’d say about $9k.
I agree with you Ed, 1k isn’t enough. I have a goal to reach 10k in emergency account having 2k in savings and 7k in stocks to get better return although I will be taking a bigger risk. But I couldn’t find a better alternative to low interests provided by savings accounts.
Nice article. I brought my own savings into a higher level and have a separate savings account for each goal. For example insurance 420 annually and i am saving 35 monthly for it, ASHRAE membership $190 annually, saving 16 monthly, my registration plates + property owners dues 374 annually and I save 35 monthly. This brings me a peace of mind when I receive a bill and I have cash ready to pay it. Same is with plans for vacation, x-mas gifts etc. The only quest I have now is to find a better vehicle than savings accounts which will make my money liquid and making better interest than 0.9% APY…