Preparing for the worst: How much should you have in your emergency fund?

by Miss Minchin, Dean of Students
If you lost your job tomorrow, would you be able to get by until you found another job, even if that job search took you 8 months? What if you and your partner both lost your jobs? Do you have enough saved up for such an emergency? Do you even know how much you need to have saved for such an event? If you are like most Americans the answer is no.

We have all been touched in some way by the current recession, and we all probably know people who have lost their homes, their jobs, or are simply struggling to get by. If there is one positive thing that we can take away from this recession, it’s that we are relearning the value of living within our means and setting aside cash for unexpected life events. More and more people are starting to appreciate the peace of mind that comes with having a solid emergency fund in place. My goal is to give you the information and tools you need to figure out the right amount to have in savings for this worst case scenario.

First you need to know the numbers
Do you know what your monthly expenses are? Do you know what they would be if both you and your partner were unemployed? Do you know how much unemployment you would qualify for? How long you would qualify for benefits? Do you know how much Cobra would cost? Let’s take a look at some of these numbers:

• In my state, Unemployment Insurance will pay half of what you make today, up to a cap. The max is $628/week for up to 30 weeks, for a total of pay out $18,840, so anyone making more than 65k/year will be getting less than 50%. In other words, if you make $65k per year, you'd be living on a salary of  $32k year for about 4 months. If you make $32k a year, you'd be living on a salary of $16k for four months or so.(Currently there are extensions in effect, but you can’t count on that in the future and likely wouldn’t qualify if you were laid off tomorrow).

• You might be thinking, “my employer will be generous with severance pay" and I hope that's true. Don’t forget that the company will have to withhold taxes & social security from your severance check, so the lump sum you may be counting on could be a lot less than you expect. When my husband was laid off last year, the $12k check we were expecting for severance and employment assistance was a lot closer to $6k. Did you also know that you cannot collect unemployment for the amount of time that you are covered by severance pay? So if you get 2 months severance, you won’t be eligible to start collecting unemployment for two months. Not only that, but if you do earn any side income while looking for a new job, your unemployment check can be reduced by that amount (see your state's Department of Labor site for the rules).

• COBRA will keep your family covered by medical insurance, but you will have to pay the full premium yourself. (Currently there is a program in place that will reimburse you for up to 80% of the premium, but you have to qualify, there is no guarantee it will exist in the future, and you will still need the money to pay the premium first). At my place of employment, for a single person with the least expensive plan you would pay $150/month, and for a family covered by the high value plan you would have to pay $1462/ month to keep your current coverage. Add to that Dental and Vision coverage and you would be paying anywhere from $200/month up to almost $1600/month. Find out what COBRA would cost you if you were to be laid off.
 
Next figure out your monthly budget
Now that you know these numbers, work these into your monthly budget to come up with amount you would need to get by in a worst case scenario. Don’t forget to count bills that are paid annually. If your monthly budget seems high, you may want to analyze your spending to separate out what your true needs are, from the nice-to-haves. One exercise to help you do that is to picture yourself and your family in a homeless shelter getting a meal from a soup kitchen. Now start adding back in the things in life that you really need. This will help you to see what things are truly necessary to get by, and which things are optional in time of need.

Identify your safety net
Once you have a worst-case scenario budget, think about what dollar amount you would need to have in the bank to feel secure. Some financial gurus recommend saving 8 months of living expenses, this is based on the average length of time it takes to find a new job in a recession. Most will recommend a minimum of 3 months of living expenses or income. Think about what number sounds right to you. What dollar amount will make you feel protected? Everyone has a different level of risk tolerance, and many factors come into play: Is your job in an industry where it is taking even longer to find employment? Do you feel confident that you would get a new job quickly? If you rely on irregular income or commissions you may want to have more, if too much money sitting safely in savings makes you feel the pinch of lost investment opportunity, you may want to save less.

Don't play games with credit
If you have credit card debt or a home equity line of credit or loan, think twice about how you would allocate funds to these. In the recent past many financial advisors gave the advice to pay down debt and use your home equity line of credit or a credit card to pull you through a crisis. But if this recession has taught us anything, it’s that we can’t count on our homes steadily increasing in value, and many of us have lost any equity that we may have had. Creditors are shutting down credit for even the most responsible consumers. As soon as you pay down debt, they are reducing your credit limit to the amount owed. Relying on these tools in an emergency can leave you even deeper in debt. A better approach may be to pay the minimum or a small amount on any existing debt until you have a reasonable emergency fund stashed away. This way you won’t find yourself both without money and without credit.

Now start saving
Once you know the amount that you would personally need to feel covered in the event of an emergency, assess your budget and find funds to put away each month to work towards that goal. Take advantage of automatic savings programs to pay yourself first, and celebrate the progress you make toward that goal. Don’t give in to temptation. When you find yourself thinking "I should live for today, I work hard, I deserve it!"  You’re right, you work hard and you do deserve it, but that is irrelevant. You will need to make some sacrifices, don’t ransom your future for short-term gratification.

In uncertain economic times, it helps to know that you are taking steps to control your financial destiny. With knowledge, a good plan, and determination, you can put your financial fate into your own hands and feel confident that you can weather any storm life throws your way.