Updated: April 26, 2018
How much money should you save as your emergency fund? The simplest and most basic answer is 6 months worth of your income.
The rationale behind this figure is because it normally takes around 6 months to look for new work in the unfortunate event that you lose your job.
But of course, not everyone is an employee and sometimes, looking for a new job can take longer, specially if you’re in a competitive industry.
So what’s a more accurate way to calculate your emergency fund? The answer is that you really need to go personal on your personal finance.
Start With Your Monthly Expenses (ME)
How much do you spend each month? If you don’t know the answer, then it’s time for you to start tracking your expenses.
List down and sum up your monthly mortgage and debt payments, utility bills, food and grocery expenses, insurance premiums, transportation expenses, and a prudent budget for discretionary spending (entertainment).
We will call this amount ME (monthly expenses).
Know Your Income Margin (IM)
If you’re an employee, then you theoretically receive the same fixed amount every month as salary. This means your income margin is zero.
But if you’re self-employed, or a freelancer, then there will certainly be good months and lean months. The same goes for entrepreneurs or business-owners.
To calculate your IM (income margin), subtract your lowest monthly income from your highest monthly income for the past year.
For example, if the highest income you received in a month for the past year was P25,000 and the lowest was P18,000 then your income margin (IM) is P7,000.
Calculate Your Income Handicap (IH)
Your income handicap (IH) is a factor that relates to your ability to find a new source of income if ever you lose your current one.
For employees, this means how long you can find a new job. For freelancers, this relates to how long you can find a new client if your biggest one leaves.
And for entrepreneurs, it can be how fast you can start a new business if you decide to close your current one.
Unfortunately, there is no exact formula to calculate your income handicap. But you can start by taking half of the number of years you’ve been working at your job, you’ve had your biggest client or the years you’ve been running your business.
If you’ve been employed at your current job for four years, then your IH is equal to 2. If your biggest client has been with you for a year, then your IH is 0.5. Your business has been running for 6 years? Your IH is 3.
The rationale used here is that the longer you’ve been working at your current job, then the harder it will be for you to find a new job – because you’re older and your skills are not as competitive as before.
The same goes for freelancers, who tend to become dependent on big clients; and entrepreneurs, whose start-up skills become rusty when they focus their energies on growing their venture.
Factor Possible Emergencies (PE)
Illnesses, specially medical emergencies can leave you broke. That’s why it’s necessary to have health insurance coverage. But not only that, there will always be unexpected expenses that could arise anytime like necessary car and house repairs.
There’s no substitute for having health insurance and you should really get one. As for car and home repairs, assess possible financial emergencies that could happen under their current conditions.
For example, if your car is showing signs of distress, then note that it could break down soon. Or if you live in a flood-prone area, then calculate the financial implication if a typhoon disaster happens.
Determine the amount you’ll need to cover such possible emergencies (PE).
Having a hard time calculating? Then just ask the nearest hospital how much an appendectomy would cost then add to that the cost of four brand new tires for your car (if you have one). That’s a good estimate amount you can use for PE.
How To Calculate Your Emergency Fund
The formula to compute your emergency fund is:
Emergency Fund = (ME x 6) + (IM x 3) + (ME x IH) + PE
Roughly, this is six months worth of your monthly expenses, plus three months worth of your income margin (to cover lean months), plus several months worth of your monthly expenses with respect to your income handicap, plus extra fund for possible emergencies.
Pedro is an office employee who spends around P18,000 a month. He’s been working at his current company for six years. He has full health insurance coverage and owns a second hand car.
ME = 18,000
IM = 0 (he is an employee)
IH = 3
PE = 16,000 (cost of four brand new tires for his car)
Following the formula, his emergency fund should be around P178,000.
Maria is a freelance writer that earns P12,000 to P20,000 a month. Her biggest client is a magazine where she’s been contributing articles for two years now. She has no health insurance and doesn’t own a car. Her monthly expenses range from P10,000 to P15,000 a month.
ME = 12,500 (average monthly expense)
IM = 8,000
IH = 1
PE = P100,000 (total cost of an appendectomy in the nearest hospital)
Again, by following the formula, her emergency fund should be around P195,500.
Did you notice how the lack of health insurance has greatly affected Maria’s emergency fund requirements? If she had medical coverage, her emergency fund would need to be just around P95,500.
Furthermore, for Pedro in the first example, notice how car ownership required him to have more money in his emergency fund. Sure, he can disregard car expenses in his calculations, but only if he can honestly say that he can live without a car.
The given formula is one which I personally follow. It was designed from personal experience which has served me good for the past several years.
However, if you believe that the resulting sum is too high (or too low) for you, then I encourage you to devise your own formula that’s better customized to your situation.
If you’re married with kids and your parents are dependent on you – then the formula above would definitely fall short of what’s necessary.
Because again, personal finance is a personal matter; and nobody knows what’s best for you than yourself.
Lastly, remember that your emergency fund is your SWAN Fund – that’s extra money which allows you to Sleep-Well-At-Night.
So always make sure you have enough, and I can guarantee that you’ll survive life’s toughest financial challenges.
Get more personal finance tips by subscribing to Ready To Be Rich.
Photo credit: taxcredits