Income vs. Monthly Expenses: Use your required monthly expenses to properly size your emergency fund, not your pre-tax or take-home income
Your monthly living expenses are a small portion of your monthly income and will most likely be less than your current monthly expenses due to your ability to cut down on extras and luxuries. In many cases, you can use your required monthly expenses, instead of your income, to size your emergency fund appropriately and avoid keeping excess cash in non-earning/growth parts of your financial portfolio
The common financial rule of thumb says that you should have 3 to 6 months of living expenses in your emergency fund. But what does "living expenses" actually mean? To calculate your monthly living expenses, you need to combine the amount needed to maintain your household's physical and mental-well being along with your other monthly required payments. Surprisingly, it is possible for your monthly living expenses to be quite a bit less than your normal monthly spending. Read the full article below to find out your monthly living expenses and be surprised at how reasonable they can be relative to your income.
What can be considered living expenses for the purposes of emergency fund sizing?
The typical rule of thumb is to have 3 to 6 months of living expenses stored. Although this might not be right for everyone, it is generally a good rule of thumb because it balances the costs of having a significant portion of your wealth in cash (and possibly earning so little that inflation is eating away at it) with the benefits of having a cushion of liquid funds available should a financial storm strike. Inquisitive minds will follow with the following question: What do you mean by "living expenses?" This is an excellent question because the rule of thumb states that we need to look at living expenses as opposed to income.
Living Expenses vs. Income
Living expenses are not income, but instead mean the total amount of money needed to provide for the needs (as opposed to wants) of you and your household, maintain financial security, and keep you out of financial default. In a financially healthy situation, living expenses should be substantially less than your pre-tax income and less than your post-tax income by a significant amount.
Note: If you find yourself in the unsustainable situation where your monthly living expenses exceed your monthly income, you are headed for a financial catastrophe (unless you're expecting some sort of windfall) and you should immediately attempt to remedy the situation.
How to properly calculate your monthly living expenses so that your rainy day fund can be sized accurately - not too big, and not too small
To get at your monthly living expenses number, we will first focus on the expenses required to maintain immediate life, health, physical, and mental well-being of your household:
But living expenses aren't enough - you've got to think about required monthly payments (eg. student loans, credit cards, etc.) when determining the appropriate size for your emergency fund
After we have taken care of the basic necessities, we will need to tabulate your required monthly payments in order to properly calculate your monthly living expenses. You want to stay out of financial default and maintain any sort of insurance you have in place even in a financial emergency, so it is important to account for the following:
Remember that this is a very general guide meant to be used by a variety of people. Your situation is unique and it is possible that your monthly expenses may be different by a little or a lot from what we discuss here. Things such as the number of dependents, unique family situations, unique jobs and businesses, unique medical or mental health needs, or unique lifestyles might cause your situation to be different from the typical scenarios discussed here.
If you've been using monthly income to determine the size of your emergency fund, it might be a bit too big
If you're a true financial nerd you can put numbers to each of the above items and calculate the current projected monthly living expenses for your household (it's only going to be a projection because things are random in this world and things can change at any moment). If you're not yet a hardcore financial nerd, it might be enough to just glance over the items and roughly estimate the amount needed in your mind (provided you understand that this will be a less accurate estimation of your monthly living expenses). Either way, you will likely come to the conclusion that your true monthly living expenses as needed to calculate the size of your emergency fund are less than what you currently spend on a monthly basis. This is generally true fro the following two reasons:
Although your monthly living expenses don't have to be the size of your actual monthly expenses, it is wise to remember that a conservative approach will lead to a more robust emergency fund and a more resilient financial situation for you. Err on the side of caution and don't be overly aggressive in estimating how much you can cut down during a financial emergency.
I know it's not fun reading the above - no one wants to cut out their premium bottled waters, their dinners out, movies, app and music purchases, premiums soaps and shampoos, or anything else they enjoy doing. If you're in a financial emergency, however, it is wise to buckle down for a bit until you get back on your feet. Discipline and short-term self-denial can be excellent tools for quickly recovering form a financial emergency minimally scathed. The knowledge that you can buckle down and survive with a diminished lifestyle for a short period of time is useful in figuring out how much money you'll need in your emergency fund.
In conclusion, you don't need to use your monthly income when calculating your emergency fund - your monthly living expenses are likely to be significantly less than your income. Additionally, you can cut out extras and luxurious and only focus on the necessities described above when calculating your monthly living expenses. This will allow you to get a better and more accurate picture of how much you need have in your emergency fund and you'll see that you can fill up your emergency fund much more quickly because of this. However, remember to not be overly optimistic about how much you can really live on - be realistic with a conservative outlook and you should be fine.
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