Financial emergencies can come in many shapes and sizes. From the small, unexpected car repair to the life altering permanence of long-term disability. In this post, we'll share with you the various types of emergencies to help you get a better idea of how much you should keep in cash reserves.
Minor, Everyday - Under $1,000
This type of emergency happens all the time. In any given year, they could crop up several times with the most common manifestations being car repairs, replacement of appliances, minor illnesses, short periods of lost work hours, and unexpected cost overruns, among others. Because these things happen so regularly, it's important to set aside at least $1,000 in your cash reserves and have what Dave Ramsey refers to as a 'Baby Emergency Fund'.
Mid-Sized, Relatively Common - $1,000 to $5,000
This next category inflicts a little more financial pain as a result of more serious issues. This can include automobile accidents that require payment of a deductible, a more significant medical or health insurance bill, a simultaneous piling up of everyday emergencies, and others. Generally, these will range from $1,000 to $5,000, and have the potential to cause some financial ripples. Since these are relatively common (usually once every year or two), holding around $5,000 would provide a nice buffer, and if you have a high deductible health insurance plan, it's almost a necessity.
Major, Not Uncommon - $5,000 to $10,000
Next we get into major issues that traditionally take the form of major medical problems, a fire, flood, or other property loss requiring a large deductible payment, substantial loss in income, etc. In these cases up to $10,000 may be required to set things right, and it takes a fair amount of time to recover from the emergency. If you make $50,000 annually, this represents up to 20% of your pre-tax income or 25% of your after-tax income, and with the average savings rate around 5%, it could take a few years to get back to even.
Mega, Relatively Rare - $10,000 and Up
Extended periods of unemployment, major medical, disability, fire, flood, theft, or other un- or under-insured event, losing a lawsuit, and many other problems can wreak havoc on your finances. Typically, when a mega-emergency comes up, it will be the result of lost income, inadequate insurance, or both. While you can insure against many of the common causes of mega-emergencies, unemployment is a different story. A sharp downturn in the economy (as we're experiencing now) can cause widespread, indiscriminate unemployment. Regardless of the cause, this type of emergency invariably creates a great deal of financial pain and can lead to bankruptcy.
Wrapping Up
The majority of emergencies fall in the first two categories and won't kill your finances. However, if you fail to adequately plan for these, you can fall into a constant cycle of digging out from relatively small emergencies - leaving you more vulnerable to bigger problems. In addition, having suitable insurance policies in place is critical in averting mega-emergencies. The right policies for you will be based on the annual premiums and the required deductible in the event of a loss.
While you can set aside a fair amount of cash and obtain the right insurance coverages, you'll always be vulnerable to unemployment (or for the self-employed, serious declines in income). Keeping your skills sharp can help, but the risk isn't insurable. As a result, the number one item to consider in how much to keep in your emergency fund is your risk of un- or under-employment.
To put this more simply, the amount you keep in your emergency fund should be the greater of mid-sized emergency costs or the amount of lost income from a stint of un- or under-employment.
Critical Thinking
- An emergency fund is the same as running your own insurance plan and is also known as self-insurance. If selling, general, and administrative expenses are lower for an individual than an insurance company, why wouldn't more people self-insure?
- Insurance is available for many 'small emergencies' including extended warranties on appliances, automobiles, and other bigger ticket items. Knowing that selling, general, and administrative expenses are lower for you than the company offering the warranty, is it smarter to self-insure or buy the warranty?
- If most mega-emergencies are caused by inadequate insurance and unemployment, does that mean that to truly be financially secure, you must carry both the right insurance and a healthy stash in cash reserves? Could you get by with one and not the other? Which would you rather have - insurance or cash?
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