Now that you know the 5 Steps to a Fully Funded Emergency Fund, it’s important to define what one month worth of expenses means. You might think it is a simple as looking over your budget to see how much you spend each month, and using that number. However, you’ll hopefully have some areas in your budget that you can cut back on while you go through an emergency. To prepare for a potential emergency, you need to figure out what a bare bones budget would look like. Remember, you only should be accessing your emergency fund when you are in full on crisis mode.
Go through your budget and put a check mark next to all fixed expenses. Fixed expenses are expenses that remain the same month after month. Fixed expenses include mortgage or rent, HOA dues, car insurance, home insurance, and your cell phone, cable bill, and internet bill. Think of fixed expenses as the expenses that will be there no matter what, and they are the same amount every month. Fixed expenses are very insensitive. They don’t care if you lost your job or if you are facing a financial hardship, you have to keep paying them regardless. Total up all of your fixed expenses.
Examine all of the variable expenses in your budget. Variable expenses can change month to month, and include entertainment, food, clothing, and gifts. You have control over your variable expenses. Look at each variable expense and reduce it down to the minimum amount you’ll need to get by, until the emergency is behind you. For instance, you can probably cut gift giving out of your budget for the purposes of calculating the amount need in an emergency fund, but you will still need to allocate money towards food. You should be able to reduce your food budget by trimming it down to the bare necessities.
Some expenses like cable, internet and a cell phone are optional fixed expenses. They are optional (if you are no longer under contract), but you might not choose to get rid of them during an emergency because of the hassle. If you feel you can’t live without a cell phone, then it represents a fixed expense you’ll need to account for. Cable is an expense many have already cut out of their budgets, but, for those still paying, decide if cable is something you can cut out when emergency strikes. Cable companies make it absurdly hard to cancel, so decide whether you think you would actually go through with the cancellation process if you're facing a financial emergency. You might be optimistic about getting through the emergency quickly, and decide not to go through the cable cancellation process.
When calculating a month’s worth of expenses for your emergency fund, you don’t need to include the amount that you put aside towards savings, investments and retirement each month. The number one reason I think people should have an emergency fund is to protect against losing a job. If you lose your job, you won’t have any extra money to put towards savings and investments, so don’t worry about it. Focus your effort on getting back on your feet, and the sooner you do that, the sooner you’ll be back to building up your investments.
Total up all the expenses that you know will be there in the event of an emergency, and that number represents one month worth of expenses for your emergency fund.
Every time your fixed expenses change be sure to update your bare minimum monthly payments amount. For example, if you bought a bigger home and your monthly mortgage went from $1,750 to $2,000, you need to account for the $250 difference.
The key to correctly calculating one month’s worth of expenses is to be honest with yourself. If you feel like you can’t ever live without Netflix, include that in your month’s worth of expenses. Don’t exclude an expense if you know it will be there when an emergency strikes.