Most people will have heard about the need to establish an emergency fund on numerous occasions. After all, no one can predict the future with perfect accuracy, meaning that it makes sense to have some money stashed away so that it can be used to cover the unexpected costs that can come up. With that said, while most people agree about the need for an emergency fund even if they are either unable or unwilling to establish such a thing, there is still significant debate over how much they should put into it.
What Does “Rules of Thumb in Household Savings Decisions” Say About Emergency Funds?
Recently, a pair of economists named Jorge Sabat and Emily Gallagher published a report called “Rules of Thumb in Household Savings Decisions” that had some interesting things to say about establishing an emergency fund:
Each Dollar Has Diminishing Usefulness
In economics, there is something called diminishing marginal utility. Essentially, when someone consumes either a product or a service, they gain utility, which can be summed up as the value that they receive from making that particular consumption choice. Diminishing marginal utility says that there will come a point when each additional unit consumed will provide said individual with less and less utility, so much so that it is possible for further consumption to start resulting in negative utility. On the whole, this is a pretty intuitive concept. For instance, suppose that someone enjoys cake. Certainly, they will enjoy their first few slices of cake, but they will enjoy each subsequent slice less and less. Eventually, there will come a point when they are so full as well as so fed up with cake that eating further slices will actually alienate them, which is a perfect example of someone getting negative utility from consuming additional units of a particular product or service.
Perhaps unsurprisingly, the report found that past a certain point, each additional dollar that is put into an emergency fund has a diminished effect on the chances of the saver suffering from financial hardship. Once again, this makes intuitive sense. For an extreme example, there is a huge difference in the range of problems that can be solved with $5,000 in savings and the range of problems that can be solved with $10,000 in savings. There is still a considerable difference between the range of problems that can be solved with $10,000 in savings and the range of problems that can be solved with $15,000 in savings, but the difference isn’t as big as in the previous sentence because the usefulness of each additional dollar has fallen by that point.
Recommended Minimum of $2,467
The two economists posted a recommended minimum of $2,467 for low-income households, which is about one month’s earnings for a household with about $30,000 in annual earnings. It is critical to note that this is the recommended minimum rather than the recommended size of an emergency fund, which are two very different things with very different implications. As such, if interested individuals can save more, they should save more.
Different Households Have Different Needs
Moving on, it should come as no surprise to learn that different households have different needs when it comes to what they should have in their emergency fund. For instance, the two economists outright suggested that single mothers as well as households without health insurance should have an additional $1,000 in their emergency fund at the very least. Something that makes a lot of sense because these two kinds of households are likelier to have higher costs in the event of an emergency coming up, meaning that it is a good idea for them to be better-prepared for such contingencies. Of course, interested individuals will also have to consider a wide range of other factors that include but are by no means limited to their local living costs, their household costs in an average period, and their other fallback options in the case of an emergency.
How Can You Save For an Emergency Funds?
Ultimately, establishing an emergency fund is critical. Furthermore, while interested individuals don’t necessarily have to save up enough to cover their costs for years and years to come, they should still save up enough to cover them for a few months if need be. Unfortunately, saving up money can be much easier said than done, though interested individuals might find it helpful to consider some examples of how other people have managed such feats:
Cut Unnecessary Expenses
This is one of the most common recommendations. In short, expenses can be separated into needs and wants. Needs are things that we need to survive such as food, water, and shelter. In contrast, wants are things that we enjoy but don’t really need for day-to-day survival. This is likely to make interested individuals less happy, but cutting out some of their spending on their wants such as unnecessary subscriptions and overly expensive service plans is a tried and true method for freeing up funds that can be moved into an emergency fund.
Reduce the Cost of Necessities
On a related note, just because necessities are necessary, it doesn’t necessarily mean that interested individuals have already squeezed out everything that they can in this regard. For example, cooking at home rather than eating out is a simple and straightforward method for saving on food costs. Likewise, public transportation can be cheaper than commuting in a car day after day depending on the options that are available to interested individuals.
Use Psychological Tricks
There are a lot of psychological tricks that can be used to help interested individuals save enough money to establish an emergency fund. One example would starting with small, short-term goals before moving on to bigger and bigger goals as each one is met. The idea behind this is that each small success will drive the next, thus increasing the chances of interested individuals persevering rather than giving up. Another example would be just automatically depositing a set percentage of the paycheck into the savings acount, which makes it much more difficult for most people to come up with excuses for why they can hold off on saving until their next paycheck.