Most financial experts recommend having an emergency fund – enough money to prevent a small emergency from becoming a major emergency. While most experts recommend you have an emergency fund, not all experts agree on how much you should keep in your emergency fund.
Some experts recommend a month of living expenses, and some recommend as much as six months living expenses. But the word emergency usually refers to something that requires immediate attention and is relatively short-lived. Somewhere between one and six months, the word emergency changes to catastrophe.
Can You Survive a Financial Catastrophe?
Many events can have a catastrophic effect on your finances. However, many of them are avoidable or can be mitigated with insurance.
A fire, flood, or other natural events could destroy your home, but if you have homeowner’s insurance or renter’s insurance, you may be covered for the loss of your home or belongings. Similarly, full coverage insurance on your vehicle can go a long way toward covering your losses.
In these cases, you will most likely only have to pay your deductible, and you are on your way. Hopefully, your emergency fund is large enough to cover your insurance deductibles and any associated costs.
Issues of health and loss of life are very different from the loss of your home or belongings, especially since they have a more personal aspect to them.
These events aren’t pleasant to think about since they affect the people we love, but again, the financial aspects can be minimized through health care insurance, disability insurance, long term care insurance, or life insurance.
As noted above, insurance policies can cover the majority of your losses and your emergency fund is there to help you through the rest of the emergency. Hopefully, your combined emergency fund and insurance policies will help prevent your emergency from mutating into a financial catastrophe.
But even with the many types of insurance plans available, some events can escalate from an emergency to a catastrophe. It could be a lack of insurance coverage, a combination of events, or something many people underestimate: unemployment.
Would Unemployment be Catastrophic to Your Finances?
Unemployment is one of the most difficult financial challenges people can face. The first and most important reason is the loss of income. The second reason is that most people aren’t prepared for unemployment. Many people underestimate how long it will take them to find a new job to replace their lost income, or they overestimate how much assistance they will receive from unemployment insurance benefits.
The maximum unemployment insurance benefit varies by state, but $400 per week is near the national average (and yes, you have to pay taxes on unemployment benefits). The amount of benefits received can also vary depending on the income the recipient made before they were unemployed, how long they have been paying into the system, whether or not they have received benefits recently, etc.
This sudden decrease in income can be devastating to one’s financial situation if it is prolonged. Could you handle an income drop from $5,000 per month to $1,600 per month? What would it do to your budget? How long could you last before it became catastrophic?
Do You Need a Personal Catastrophe Fund?
A personal catastrophe fund is the same thing as an emergency fund, but on a larger scale. It should be designed to help you replace a larger amount of lost income for a longer period of time than a standard emergency fund (remember emergencies are immediate, and catastrophes are more significant and more drawn out). So the question is, do you need one, and if so, how large should it be?
Do you need a catastrophe fund? Not everyone needs a personal catastrophe fund. For example, if you are well insured, have a sizable emergency fund, and your income is very secure, then you might be well prepared (financially) for anything life throws at you. But you may wish to start a catastrophe fund if you don’t have enough or aren’t able to purchase the right insurance policies, or if your job is high risk. Here are some questions to ask yourself:
- Do you have sufficient insurance? If not, can you purchase it?
- How long will your emergency fund last in a worst-case scenario?
- How large are your fixed expenses?
- Do you have additional investments you can sell? What about home equity you can tap?
- How stable is your job? Your industry?
- How long will it take you to find another job?
How large should your catastrophe fund be? The answer to this question will vary by person. Again, you want to consider your insurance policies, overall health, the size of your emergency fund and how long it will last, additional investments you might be able to tap, your fixed expenses, your career prospects if you lose your job, etc.
If you believe your situation adds up to a higher risk profile, then you may wish to start your savings at six months worth of living expenses, and add from there.
What do you think about a catastrophe fund? Necessary, or over the top?