Money Sundays: The "Stoplight Rule" For Creating An Emergency Fund

Readers, here’s a piece of personal finance wisdom so useful... that I decided to steal it. It's a set of rules for how to think about your emergency fund (or cushion, as Your Money Or Your Life devotees would say). It’s courtesy of the Aleph Blog:

The Stoplight Rule for managing your emergency fund:

* Less than 3 months expenses in the savings fund? Red light. Defer all discretionary expenditures.

* 3-6 months expenses in the savings fund? Yellow light. Some discretionary expenditures allowed, so long as you don’t dip back into the red light zone.

* More than 6 months expenses in the savings fund? Green light. Discretionary expenditures allowed, so long as you don’t dip back into the red light zone.

I’ll add a few of my own opinions to this stoplight metaphor. First, I’d double all of these metrics. I believe six months is a bare minimum to hold in an emergency fund--nine months to a year’s worth of expenses is better. And an admittedly aggressive goal very much worth striving for here is two years of expenses.

Yes, it's an ambitious goal to save two years' worth of expenses in your emergency fund, no doubt about it. But it will also be an incredibly freeing place to be once you reach it. It's enough to protect from an extremely long period of unemployment. It's enough to support you through a significant career change, a trip back to grad school--even a long sabbatical.

And there is enormous psychological value to being able to last two years without any income. It may very well transform how you think about work. Petty dramas like office politics or unlikeable coworkers will seem totally unimportant--as they should be. The implied freedom of two years' worth of dough in the bank puts all that silliness in proper perspective. But importantly, a buffer of this size will liberate you to take intelligent risks with your career. After all, what’s the worst that could happen? You might lose your job, of course. But then you’ve got two full years to find a new one.

For us here at Casual Kitchen, hitting the "two years of expenses" benchmark helped us believe that we could take things further--and it laid the groundwork for us to hit a three year buffer, a five year buffer, a ten year buffer and so on. [For more on this, see my post Extreme Savings.]

A final word. Don't beat yourself up or indulge in feelings of inadequacy if you're carrying a smaller emergency fund than some personal finance blogger says you should. As you can see above, opinions differ on this issue. But here's the thing: most people never get around to having an emergency fund at all. You're already far, far ahead of the game if you're deciding how much should be in yours. Keep going!

Related Posts:
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Money Sundays: Get Your Big Ticket Purchases Right. The Rest Takes Care of Itself
Money Sundays: Save Money! Create an Emotion vs. Reason List
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Anonymous said...

Define "emergency fund." What if you have "over-saved" for retirement, as in: "I will be wealthier in retirement than before retirement." Does continuing to put more money into a retirement fund constitute an emergency fund, but one that actually has returns? I've always been bugged by putting money in a place with no substantial returns (like a savings account).

Further, how do you compensate for the job stability you have (or do not have)? I'm extremely income stable (benefit comes with lower than market value income). Shouldn't there be an adjustment in how much should be saved/available?

chacha1 said...

We're in the "yellow light" zone after my past year's successful savings project.

Until we actually have enough in the liquid savings fund to put a down-payment on a property, I'm considering it our "emergency fund." Though historically, we have been in the habit of using credit cards to meet unexpected expenses such as big-ticket car maintenance items (new tires: expected. rebuild transmission: unexpected.) and then pay it off out of savings or out of our regular income.

I don't consider my retirement savings to be "emergency fund," although legally we could use it that way. Taking money out of there for anything other than a true catastrophe would be long-term stupid.

We are still young enough that the most likely financial crunch scenario could be dealt with simply by moving to a less expensive apartment.

Neither of us especially wants to stop working, so that definition of financial freedom doesn't apply. If one of us HAD to stop working it would be due to a disabling event, in which case no amount of "emergency" fund would be enough.

Daniel said...

Anon: I'll field your question in an upcoming post. To an extent you're asking the wrong question.

Chacha, it's great to hear about your progress on this front. That's spectacular!