I am a big fan of Dave Ramsey, and as my husband and I pay down our debt, we follow a hybrid approach to his debt snowball method. Followers of Dave Ramsey know that another part of his debt reduction plan is to first save $1,000 in an emergency fund before beginning aggressive debt reduction. Yet is this good advice for everyone? Should some families have a larger emergency fund? What is the right amount for your family to set aside in an emergency fund?
Peter has stated that while he and his wife paid off debt, they had a $2,000 emergency fund (which they have grown considerably now that they are debt free except the mortgage). My husband and I cut it closer and only have a $500 emergency fund. As can be expected, this amount was too small, and we recently experienced a mini-financial crisis. For us, a $1,000 emergency fund is too small. We have decided to initially create a $2,000 emergency fund with our tax refund and then to divert some money to increasing the emergency fund to $5,000 while still paying down debt.
Considerations When Creating Your Emergency Fund
What is the best way to determine how much you should have in your emergency fund while reducing debt? It ultimately depends on your own comfort level for risk and several other factors:
How much debt do you have to pay off? If you have less than $8,000 to $10,000 in debt, chances are you can pay it off fairly quickly, so you may be able to get by with a smaller emergency fund. If you have a much larger amount and know it may take you longer than a year to become debt free, you should probably set aside a large amount because emergencies over the course of several years are likely to occur.
How stable is your job? In this economy, it sometimes feels like no job is truly stable and secure, but if you have a job with fluctuating income, you’ll need a larger emergency fund to see you through those periods of low income. I am a freelancer and make ½ to 2/3rds of our family’s income depending on my work for the month. I have been a freelancer for 14 months and have been fortunate to see my work increase every month until last month when I lost several clients who lost their own source of income. This was a wake up call that we need a cushion for those times when my income ebbs.
Do you own a home? If you own a home, you will likely face unexpected repairs, sometimes costly ones. Is $1,000 in an emergency fund enough to cover a sudden roof repair if you want to avoid debt? The answer is no. While you wouldn’t need the entire amount set aside, you should have several thousand dollars set aside for unexpected housing repairs.
How old is your car? A car that is only two or three years old is less likely to need expensive repairs than a car that is seven or more years old. If you have an older car, you need to have enough set aside for unexpected emergencies.
How many kids do you have? The larger your family, typically the larger your expenses and the more you should have set aside. We have 3 kids, and while they are healthy, unexpected expenses can still come up such as the three cavities the dentist recently said my son has.
Do you have insurance? If you do, how good is your insurance? If you don’t have insurance, the first thing you should do is get insurance because one accident or injury could lead you to bankruptcy. Even if you have to just have major medical or have to cover your children through state funded care, insurance is essential. However, many people do have insurance, but the coverage is poor. How much do you have to pay annually out of pocket? What is your maximum deductible? All of these answers will help you determine how big your emergency fund has to be.
How much to save in an emergency fund when paying down debt is a personal decision. We have taken risks with a very low emergency fund of $500, and we were caught off guard when several reimbursements were very slow in coming, resulting in a significant budget shortfall. That situation combined with my income actually decreasing for a month led us to the decision to increase our emergency fund. This might not be the right strategy for everyone. Use the list above to determine how likely you are to face an emergency and how much money you should set aside.
How much do you have saved in your emergency fund? Do you feel like it's enough?