back to index

RPF0197-Size_of_Emergency_Fund


Whisper Transcript | Transcript Only Page

00:00:00.000 | ♪ Bless him in the mornings ♪
00:00:03.000 | ♪ Come back Sunday morning ♪
00:00:05.000 | California's top casino and entertainment destination
00:00:08.000 | is now your California to Vegas connection.
00:00:11.000 | Play at Yamava Resort and Casino at San Manuel
00:00:14.000 | to earn points, rewards, and complimentary experiences
00:00:17.000 | for the iconic Palms Casino Resort in Las Vegas.
00:00:21.000 | ♪ Got to sort of tell 'em ♪
00:00:23.000 | Two destinations, one loyalty card.
00:00:26.000 | Visit yamava.com/palms to discover more.
00:00:29.000 | - Very focused show today.
00:00:32.000 | We're gonna cover three things.
00:00:34.000 | Number one, how big of an emergency fund do I need?
00:00:37.000 | Specifically, how would I figure that out
00:00:39.000 | in sitting for the CFP exam?
00:00:42.000 | Number two, where should I keep it?
00:00:44.000 | And number three, what are the financial ratios
00:00:47.000 | that I should apply to my household
00:00:49.000 | to figure out if the household is running in a safe manner?
00:00:54.000 | (upbeat music)
00:00:59.000 | Welcome to the Radical Personal Finance Podcast.
00:01:13.000 | My name is Joshua Sheets and I'm your host.
00:01:15.000 | This is episode 197.
00:01:17.000 | Gonna share with you some information
00:01:19.000 | that you will need if you're ever gonna sit
00:01:21.000 | for the CFP exam, but it's also applicable
00:01:23.000 | to, I don't know, what should I call us,
00:01:27.000 | normal people who aren't CFPs?
00:01:29.000 | (laughs)
00:01:30.000 | The point is, I'm gonna give you the technical answer today
00:01:33.000 | of how big of an emergency fund do I need
00:01:35.000 | with just a little bit of expansion for individuals.
00:01:39.000 | (upbeat music)
00:01:44.000 | You're ultimately gonna have to be the person
00:01:45.000 | to decide for yourself how big of an emergency fund
00:01:48.000 | that you actually need.
00:01:49.000 | It's a very individual decision,
00:01:51.000 | but there is a little bit of technical formal guidance
00:01:54.000 | that we can give.
00:01:55.000 | Specifically, this is the technical formal guidance
00:01:57.000 | that you would need if you were sitting for the CFP exam.
00:02:01.000 | And this way of thinking, I believe,
00:02:03.000 | you'll be able to find helpful to apply it to your life
00:02:06.000 | and think about the risk factors.
00:02:09.000 | According to the CFP board, their standards
00:02:12.000 | and their curriculum that they set out,
00:02:14.000 | or at least the way that you'll be tested on the exam,
00:02:17.000 | the way that you find an emergency fund
00:02:19.000 | is somewhere between three and six months worth of expenses.
00:02:23.000 | And so you total up, if you are presented
00:02:25.000 | with something like a budget, you total up
00:02:27.000 | all of the fixed and variable expenses for a household,
00:02:31.000 | and you're going to either choose
00:02:32.000 | a three-month emergency fund or a six-month emergency fund.
00:02:36.000 | If you ever pay attention to common personal finance advice,
00:02:39.000 | you'll often hear this three to six months number
00:02:42.000 | tossed around.
00:02:43.000 | Well, obviously, though, there's a big difference
00:02:45.000 | between three and six months.
00:02:48.000 | After all, six months of expenses is exactly
00:02:51.000 | double three months of expenses.
00:02:53.000 | So it's probably going to take you,
00:02:55.000 | if you're saving for this starting from zero,
00:02:57.000 | it may take you twice as much time
00:02:59.000 | to get to six months of expenses, which
00:03:01.000 | might delay your transitioning from building an emergency fund
00:03:06.000 | to pursuing other financial goals.
00:03:09.000 | It might delay that for a period of time
00:03:11.000 | because you've got to save all this money.
00:03:13.000 | So how would you decide?
00:03:15.000 | Well, it's based upon the risk factors of income.
00:03:21.000 | And the key is you're going to look to figure out
00:03:23.000 | how many sources of income are there in a household.
00:03:27.000 | If there are multiple sources of income into a household,
00:03:31.000 | then you probably have fewer risk factors
00:03:33.000 | of losing an income.
00:03:36.000 | If you and your spouse are both gainfully employed,
00:03:38.000 | both receiving an income, then it's possible
00:03:42.000 | that one of you will lose your job,
00:03:44.000 | but it's less likely that both of you
00:03:46.000 | will lose your job at the same time.
00:03:48.000 | So therefore, it would probably be OK
00:03:50.000 | to have a slightly smaller emergency fund
00:03:54.000 | because even in the case of one job loss,
00:03:58.000 | you would have some savings, and then you would have
00:04:00.000 | one spouse continuing to work.
00:04:03.000 | So that's basically the approach that the CFP board recommends.
00:04:08.000 | And when you're sitting for the exam,
00:04:09.000 | if you're a prospective financial planner,
00:04:11.000 | you will always look and try to figure out
00:04:13.000 | how many sources of income there are into the household.
00:04:17.000 | If you have a single wage earner,
00:04:20.000 | one individual person in a household,
00:04:22.000 | then you're automatically going to recommend
00:04:24.000 | a six-month emergency fund.
00:04:27.000 | Or if you have a married household,
00:04:31.000 | but only one spouse is earning income,
00:04:34.000 | then you're also going to automatically recommend
00:04:37.000 | a six-month emergency fund.
00:04:39.000 | In those cases, the concentration of risk
00:04:41.000 | in a single job is quite high,
00:04:43.000 | so you'll always transition to that six-month emergency fund.
00:04:46.000 | However, if you have a single wage earner
00:04:49.000 | who has a second source of income of some type,
00:04:53.000 | in that case, you're going to go ahead
00:04:55.000 | and look to a three-month emergency fund,
00:04:58.000 | and that's the answer you're going to suggest
00:05:00.000 | on the CFP board exam.
00:05:02.000 | Or if you have a married household
00:05:04.000 | where both spouses are earning income,
00:05:08.000 | or if you have a married couple
00:05:11.000 | where only one spouse is working,
00:05:13.000 | but the other spouse has another form of income,
00:05:15.000 | for example, another spouse is receiving alimony payments,
00:05:20.000 | or perhaps one of the spouses or parties is very wealthy,
00:05:24.000 | has investment accounts that they're pulling money from,
00:05:27.000 | they're financially established and basically well-funded,
00:05:31.000 | or if there's a large trust fund providing income,
00:05:34.000 | rights of withdrawal, something like that,
00:05:36.000 | under those circumstances,
00:05:38.000 | then you're safe to go ahead
00:05:40.000 | and recommend the three-month fund.
00:05:43.000 | It's as simple as that, and that's what you need
00:05:45.000 | if you're going to take the CFP board exam.
00:05:48.000 | That's what you need to remember.
00:05:49.000 | Now, if you are looking at this
00:05:52.000 | for your own personal financial planning,
00:05:54.000 | for your own household,
00:05:55.000 | just take this concept and extend it,
00:05:58.000 | and the importance is looking at
00:06:00.000 | how risky are my sources of cash flow.
00:06:05.000 | The problem with the recommendation
00:06:07.000 | of three to six months is that it's necessarily vague
00:06:10.000 | because it's applying to a general population.
00:06:13.000 | It's okay if you make a choice to extend that out
00:06:17.000 | and you say, "I feel more comfortable
00:06:18.000 | "with a one-year emergency fund,"
00:06:20.000 | or if you want to,
00:06:22.000 | I wouldn't go much below three months of expenses,
00:06:24.000 | but you can choose your own number.
00:06:27.000 | But look at it with the same principle in mind
00:06:29.000 | and say, "What are the risks to our household
00:06:33.000 | "if we lose our income?"
00:06:37.000 | Now, what assets qualify as being useful
00:06:41.000 | for saving in an emergency fund?
00:06:44.000 | Number one, currency, cash, dollar bills,
00:06:47.000 | or whatever the currency of choice is in your environment.
00:06:51.000 | That's obviously useful and applicable
00:06:53.000 | as being counted in the emergency fund.
00:06:55.000 | Any checking accounts,
00:06:57.000 | as long as you are not planning on funds
00:07:00.000 | that are normally used for day-to-day living expenses.
00:07:03.000 | So it'd be good to have emergency funds
00:07:06.000 | allocated into a different account,
00:07:08.000 | into a different checking account,
00:07:10.000 | or also some kind of savings account.
00:07:12.000 | That would be good.
00:07:14.000 | Government money market accounts
00:07:16.000 | or CDs that have a short-term maturity,
00:07:20.000 | less than or equal to,
00:07:22.000 | if you're going by the official CFP board standards
00:07:24.000 | for trying to figure out when looking at a balance sheet,
00:07:27.000 | which of these accounts can I use as an emergency fund,
00:07:29.000 | less than or equal to 90 days,
00:07:31.000 | or a laddered CD program
00:07:33.000 | with maturities of less than or equal to six months?
00:07:37.000 | So if you're a financial planning practitioner,
00:07:39.000 | look for those accounts,
00:07:40.000 | and those are the accounts that you can use
00:07:43.000 | if presented with a balance sheet.
00:07:44.000 | Those are the accounts that you can use
00:07:46.000 | to say that these are part of the emergency funds.
00:07:49.000 | Checking accounts, currency, savings accounts,
00:07:52.000 | government money market accounts,
00:07:53.000 | and CDs with a maturity of less than or equal to 90 days,
00:07:57.000 | or laddered CDs with a maturity of less than or equal to six months.
00:08:03.000 | There are no other asset classes that will formally qualify.
00:08:07.000 | There are other assets that might be stable enough
00:08:10.000 | to be used as a portion of your savings accounts,
00:08:13.000 | but there are no other asset classes that will formally qualify
00:08:16.000 | for the purposes of the CFP board exam.
00:08:19.000 | Finally, let's talk for a moment about ratios.
00:08:24.000 | These are some ratios that financial planning practitioners
00:08:27.000 | are tested on on the CFP board exam.
00:08:31.000 | There are also ratios that you should sit down
00:08:33.000 | and take a look at your own personal budget.
00:08:36.000 | These are the recommendations for the general population,
00:08:39.000 | so they're probably not as hardcore as many of you who are listening,
00:08:44.000 | but it's still a good way to test yourself
00:08:46.000 | and to make sure you're at least within the guidelines
00:08:48.000 | for the normal population.
00:08:51.000 | The first ratio is what percentage of your income
00:08:56.000 | should your total housing expenses be?
00:08:59.000 | So housing expenses in this circumstance would be defined
00:09:02.000 | as either your mortgage payment, inclusive of principal, interest,
00:09:07.000 | taxes and insurance, or your rent payment.
00:09:12.000 | Either one of those would be fine,
00:09:14.000 | and that number should be either 28% or less
00:09:19.000 | of your total household budget.
00:09:22.000 | So the way that you figure this out is take either your monthly--
00:09:25.000 | excuse me, your annual mortgage.
00:09:27.000 | You could do it either on a monthly basis or on an annual basis.
00:09:29.000 | I'll do it on an annual basis here.
00:09:32.000 | But take your monthly payment and divide that into your gross income,
00:09:36.000 | your total amount of income, and for good financial health,
00:09:39.000 | that number should be 28% or less.
00:09:42.000 | So as an example, let's say you have an income of just above median income,
00:09:46.000 | so call it $50,000 per year,
00:09:49.000 | and let's say that your monthly rent payments
00:09:52.000 | or your monthly principal, interest, taxes, and insurance payment,
00:09:55.000 | your total mortgage payment if you're escrowing taxes and insurance,
00:09:59.000 | your monthly payment is $1,000.
00:10:01.000 | Take $1,000, multiply that times 12.
00:10:03.000 | That gives you your total annual expenditure.
00:10:06.000 | Then divide $12,000, divide that by $50,000 for your annual income,
00:10:11.000 | whatever your total gross annual income is,
00:10:14.000 | the amount of income before taxes and expenses.
00:10:18.000 | That will give you a percentage ratio.
00:10:21.000 | So in that example, it would be 24%.
00:10:24.000 | If you were earning $50,000 per year household income
00:10:27.000 | and you're spending $1,000 a month on housing expenses, that would be 24%.
00:10:32.000 | That would be good health.
00:10:34.000 | Again, some of you will be far more extreme than this, some of you will not.
00:10:37.000 | But at least on the general population
00:10:39.000 | and specifically with regard to the CFP board exam,
00:10:42.000 | that number needs to be 28% or less of your gross income.
00:10:46.000 | If your housing expenses are higher than that for you as an individual,
00:10:51.000 | consider why and consider making changes.
00:10:55.000 | It can start to be dangerous if your housing expenses are higher
00:10:58.000 | than that number in your monthly budget.
00:11:01.000 | Another number that the CFP board will test on is
00:11:06.000 | what should be the ratio of your total monthly debt payments
00:11:10.000 | as compared to gross income.
00:11:13.000 | The number there that they've selected is
00:11:15.000 | your total monthly debt payments should be 36% or less of your gross income.
00:11:22.000 | So any debt payments at all, that can include mortgage,
00:11:27.000 | that can include consumer debt, car loans, student loans,
00:11:30.000 | any of those numbers should be 36% or less of your gross income.
00:11:35.000 | So take your gross income, let's just use that $50,000 number again,
00:11:40.000 | and then simply choose 36% of that and that would be $18,000.
00:11:44.000 | So for a just over median income household,
00:11:47.000 | $1,500 a month should be the maximum amount of the total debt payments.
00:11:54.000 | The final ratio is what percentage of income should consumer debt be.
00:12:00.000 | And in this case, the CFP board has chosen the number of 20% of net income.
00:12:08.000 | So here you would take your income after taxes and deductions
00:12:13.000 | and whatever that number is,
00:12:15.000 | at least the consumer debt should be at least less than 20%.
00:12:21.000 | And if you'll run those numbers,
00:12:23.000 | you can start to get an idea of where you stack up.
00:12:27.000 | If your ratios are higher than those numbers,
00:12:31.000 | that should be a red flag for you.
00:12:34.000 | So if your housing expenses are higher than 28% of your gross income,
00:12:39.000 | or if your total monthly debt including housing expenses and consumer debt
00:12:44.000 | is greater than 36% of your gross income,
00:12:48.000 | or if your consumer debt is greater than 20% of your net income,
00:12:54.000 | that should be a big red flag and you should take steps to arrange that,
00:12:59.000 | to improve the situation because it puts a lot of stress on your budget,
00:13:03.000 | puts a lot of stress on the household,
00:13:05.000 | puts a lot of stress on your overall plan because the ratios are too high
00:13:10.000 | to give some wiggle room and some freedom.
00:13:13.000 | And obviously, the lower you can get those numbers, the better.
00:13:17.000 | Finally, for CFP board students,
00:13:22.000 | make sure that you know how to calculate what we call a current ratio.
00:13:28.000 | Usually, you'll use the concept of ratios, liquidity ratios,
00:13:32.000 | and current ratios when looking at business calculations.
00:13:36.000 | But from time to time,
00:13:38.000 | you will see these applied to personal financial statements.
00:13:42.000 | And you want to make sure that you know how to do a current ratio calculation.
00:13:47.000 | It's very simple.
00:13:48.000 | You take current assets and divide those by current liabilities.
00:13:54.000 | Current assets would be cash or cash equivalents,
00:13:57.000 | marketable securities, accounts receivable, and inventory.
00:14:03.000 | Obviously, that's the business definition applied over to personal financial planning,
00:14:08.000 | but I want to be precise with it.
00:14:10.000 | And then current liabilities would be accounts payable,
00:14:14.000 | credit card debt, and taxes payable.
00:14:18.000 | We don't include long-term structured debts like mortgage payments in this number
00:14:25.000 | unless we are including the current amount.
00:14:29.000 | So for example, your mortgage payment is $1,500 and $1,500 is due.
00:14:33.000 | Then you would include that,
00:14:34.000 | but you wouldn't include the total balance of the mortgage here.
00:14:38.000 | Take those current assets, divide it by the current liabilities,
00:14:41.000 | and that will give you a number.
00:14:44.000 | So as an example, let's say that you have $5,000 in a checking account,
00:14:49.000 | $10,000 in a money market account, that equals $15,000,
00:14:53.000 | and you have $3,000 of credit card debt.
00:14:56.000 | Take $15,000, divide it by $3,000, and you wind up with a number of 5.
00:15:02.000 | That's the current ratio.
00:15:04.000 | Do not include in this number for assets.
00:15:06.000 | Don't include things like 401(k) accounts or other structured long-term deferred
00:15:11.000 | assets because the cost of turning them into cash is too high to calculate.
00:15:16.000 | They're not a current asset.
00:15:17.000 | They're not a cash or cash equivalent.
00:15:19.000 | The cost of converting them into money, into cash that you can spend,
00:15:22.000 | is too expensive.
00:15:23.000 | They don't fit the definition.
00:15:25.000 | But that will give you a ratio.
00:15:27.000 | That ratio is going to be primarily useful for comparing among different
00:15:31.000 | households.
00:15:33.000 | Ratios are mostly meaningless on their own.
00:15:37.000 | If you're just running this for your own household, it's good for you to know,
00:15:39.000 | but you would need to be able to compare it to other households.
00:15:42.000 | So this would be more useful for financial planners to compare households
00:15:46.000 | or it will be just a simple answer on the CFP board exam that you might need
00:15:50.000 | to know how to do.
00:15:52.000 | So my challenge to you is if you're a CFP board practitioner,
00:15:56.000 | go ahead and learn these, or if you're an individual,
00:15:59.000 | go ahead and calculate them.
00:16:01.000 | And just check to make sure in the same way that knowing what the standard,
00:16:05.000 | say BMI or height and weight numbers are,
00:16:08.000 | that can be useful for your health to be able to judge that.
00:16:12.000 | But you have to take it with a grain of salt.
00:16:13.000 | So you take those generalized numbers,
00:16:15.000 | and if your numbers are out of the normal range,
00:16:19.000 | then look to try to figure out why your numbers are out of the normal range.
00:16:23.000 | There may be a good reason for it, but be aware.
00:16:28.000 | It can be a red flag for you.
00:16:30.000 | Hopefully this is useful.
00:16:31.000 | I know it's just a short thing.
00:16:32.000 | This is a type of concept that you need to know for the CFP board exam,
00:16:36.000 | but it doesn't fit necessarily into a larger show,
00:16:39.000 | so that's why I've chosen to do it in a very simple scenario here.
00:16:42.000 | Calculate the emergency funds, 3 months and 6 months.
00:16:45.000 | 6 months if you are a single wage earner in a household
00:16:49.000 | or have a household with one wage earner.
00:16:50.000 | 3 months if there are secondary sources of income.
00:16:53.000 | Run these ratios.
00:16:54.000 | Housing expense, 28% or less of your gross income.
00:16:57.000 | Total monthly debt, 36% or less of your gross income.
00:17:00.000 | Consumer debt should be 20% or less of your net income.
00:17:04.000 | Calculate the current ratio with current assets divided by current liabilities.
00:17:10.000 | Thank you all so much for listening.
00:17:14.000 | If this is useful to you, I would be thrilled if you'd support the show.
00:17:17.000 | The show is provided to you free of charge thanks to the goodwill
00:17:21.000 | and financial support of the listeners of the show,
00:17:23.000 | a special group of listeners that we call the patrons.
00:17:26.000 | If you would like to become a patron, please go to
00:17:29.000 | radicalpersonalfinance.com/patron.
00:17:31.000 | You can sign up at different levels and there are different incentives
00:17:34.000 | at each level for you.
00:17:36.000 | radicalpersonalfinance.com/patron.
00:17:39.000 | Thanks so much. Talk with you soon.
00:17:42.000 | ♪ [music] ♪
00:17:45.000 | ♪ [closing music] ♪
00:17:50.000 | ♪ [closing music] ♪
00:18:15.000 | Thank you for listening to today's show.
00:18:17.000 | Please subscribe to the podcast with our free mobile app
00:18:21.000 | so you don't miss a single episode.
00:18:23.000 | Just search the App Store on your device for Radical Personal Finance
00:18:27.000 | and you'll find our free app.
00:18:29.000 | If you have received value from the content of this show,
00:18:31.000 | please consider becoming a patron.
00:18:33.000 | Your financial support is how I pay the bills for the show
00:18:36.000 | and how I plan to grow our content.
00:18:38.000 | You can support the show with as little as a dollar a month
00:18:40.000 | or as much as you feel the content is worth.
00:18:43.000 | Details are at radicalpersonalfinance.com/patron.
00:18:48.000 | If you'd like to contact me personally, my email address is
00:18:51.000 | joshua@radicalpersonalfinance.com
00:18:53.000 | or connect with the show on Twitter @radicalpf
00:18:56.000 | and at facebook.com/radicalpersonalfinance.
00:18:59.000 | This show is intended to provide entertainment, education,
00:19:03.000 | and financial enlightenment, but your situation is unique
00:19:07.000 | and I cannot deliver any actionable advice without knowing anything about you.
00:19:12.000 | Please, develop a team of professional advisors who you find to be caring,
00:19:17.000 | competent, and trustworthy, and consult them,
00:19:21.000 | because they are the ones who can understand your specific needs,
00:19:24.000 | your specific goals, and provide specific answers to your questions.
00:19:29.000 | I've done my absolute best to be clear and accurate in today's show,
00:19:33.000 | but I'm one person and I make mistakes.
00:19:36.000 | If you spot a mistake in something I've said,
00:19:38.000 | please come by the show page and comment so we can all learn together.
00:19:42.000 | Until tomorrow, thanks for being here.
00:19:45.000 | Wake up at Holiday Inn Express to a can't-miss breakfast that's free with every stay.
00:19:50.000 | Count on all the hot fresh coffee you need
00:19:52.000 | and an incredible breakfast buffet that has something for everyone,
00:19:55.000 | like eggs, cinnamon rolls, and even hot fresh pancakes with all the toppings you crave.
00:20:00.000 | Next time, do yourself a favor and stay at a Holiday Inn Express
00:20:04.000 | with a can't-miss breakfast that's free with every stay.
00:20:07.000 | So, when you wake up at Holiday Inn Express, you'll wake up happy,
00:20:11.000 | a part of IHG Hotels and Resorts.