Do you have an emergency fund? That’s a subject that is often considered taboo among investors. In fact, not having an emergency fund can result in undoing years of financial progress in some cases. But how do you calculate your emergency fund?
There’s no hard and fast rule. Often, the suggestion is to save three to six months of expenses. For many, estimating how much they need and then saving tens of thousands of dollars for an emergency can seem like a daunting ask.
Fortunately, there is a better way to make that estimate, and all it takes is a few minutes, assuming that you have your budget and recent bills nearby.
Let’s calculate your emergency fund in five minutes.
Minutes 1 and 2: Calculate your emergency fund from essential expenses
Start by taking two minutes to add up all of your monthly expenses that you would still have assuming your income stopped tomorrow.
That includes the housing payment, utility bill, insurance and typical monthly grocery spending. Also on that list would be any minimum debt payments and any expenses related to childcare or dependents. That also includes essential non-monthly bills that make their way into the budget.
Leave out discretionary and entertainment spending that would come to a halt if your paycheque suddenly disappeared. That includes restaurants, streaming bills, and the monthly online shopping habit.
The key here is to find that realistic monthly amount that your household needs to stay running.
For this example, let’s assume that amount comes out to a total of $4,500 per month.
Minute 3: Answer how many months you need
If you’re looking to calculate your emergency fund, part of that is determining how many months of expenses you want to cover.
The general guideline leans toward three to six months of regular expenses. That’s just an estimate though. Some households are comfortable with less, and others opt for more than six months.
For example, a two-income household with fewer bills might feel comfortable near the lower end of that range. Another household with a single income and variable earnings may prefer to save a higher amount.
Continuing the example above, let’s opt for four months of expenses.
Given our $4,500 per month number, that leaves us with an emergency fund ask of $18,000.
Minute 4: Subtract what you already have saved
During the fourth minute, start by subtracting any emergency savings you already have from that target.
Let’s assume in this case you already have $3,000 set aside. In that scenario, you still need another $15,000 to reach that goal.
An important point here is that only money that is available to cover an actual emergency should be counted. Available room on a credit card isn’t an emergency fund. The same applies to stock holdings.
Minute 5: Put your contributions to work
Once you know the number that you need to reach, use the last minute to determine where you’ll keep that money until you need it. And if the first spot that crossed your mind was a traditional savings account at one of the big banks, think again.
Growth of that emergency fund is an area that most people dismiss. You likely won’t add the remaining $15,000 in the example above all at once.
Why not put it somewhere where each deposit can help it to compound?
That’s where a separate, accessible high-interest savings account helps. It keeps the emergency fund available when needed and separate from everyday spending.
Just choose a regular contribution that fits your budget and automate it.
Once your emergency fund reaches its target, there’s no need to stop setting money aside. Instead, future contributions can go toward long-term investing while your emergency fund stays in savings.
A great example of this is the iShares Core S&P/TSX Capped Composite Index ETF (TSX: XIC). The ETF lets you spread that regular contribution across Canadian stocks with a single purchase.
Its distributions can also support long-term compounding when reinvested.