Should Your Emergency Savings Be Based On Your Expenses Or Salary?
By now you’ve likely heard that you need an emergency savings stockpile that can last at least six months. It’s common for you to be told that it should be able to sustain you for this amount of time should you lose your job, and thus based on your monthly expenses.
On the other hand, many things can happen over half a year; and having savings that only cover basic expenses may not be enough to deal with unforeseen emergencies.
So, should your emergency savings be based on your total salary instead?
Expense based: Quicker goal to achieve, less flexible for emergencies, can allocate resources to other investments
Salary based: Takes longer to achieve, better equipped to deal with unforeseen expenses, may lose out on opportunities for investments
How long does it take to save?
Before we go into this, we should first establish that your decision should be based on your own circumstances. Each option presents its own set of opportunity costs and benefits. It’s really up to you to decide on how you want to go about this.
Here’s an example of how the two options break down. We will assume a person with an income of RM3,000 after deductions. Let’s say this person is following the 50/30/20 budgeting rule.
|Expenses (50% of salary)||RM1,500||RM1,500|
|Monthly savings (20% of monthly income)||RM600||RM600|
|Time to achieve goal with 20% savings||15 months||30 months|
|Monthly savings (50% of monthly income)||RM1500||RM1500|
|Time to achieve goal with 50% savings||6 months||12 months|
The table provides two different options depending on how aggressive you get with your savings. After all, the idea was to allow 30% of your salary for discretionary expenses; after all, you’re not a savage. However, the table also illustrates how much faster you can reach your goal if you can put more in savings in the short term.
Why base your savings on your salary?
You may be wondering why there is a choice to be made; one of these savings targets takes longer than the other and there is no guarantee that you might even need that extra savings.
Well, the idea is that you may want to create a much bigger savings buffer to account for bigger problems. You may not end up out of a job for six months at a time; but if you do, then you had better hope that nothing goes wrong during that time.
This means that your emergency savings can only cover your living expenses and do not take into account anything needing to be replaced or breaking down. So, you would be praying that your car keeps working and you don’t drop your phone.
Which is why you may want a little extra squirreled away just in case something does go wrong. This is especially important if you have gaps in your insurance coverage (which is why medical insurance is extremely important if you want to go with the expenses-based saving option).
In other words, this is the option for people who want a bigger financial buffer.
What about basing it on expenses?
Why would you opt for less emergency savings? Well, it could be because you’re in an industry that has many employment opportunities and you have an insurance policy that keeps you covered if you lose the ability to work.
If you do, then any extra savings can – and should – be put into investments for passive income generation. The difference in the short term isn’t much. Assuming you invest at a conservative 5% per annum return, you could possibly earn an extra RM261 over simply saving it all (based on saving RM600 per month outlined in the table above).
However, assuming that you have a 30-year investment plan – at the same rate of return – the numbers look very different.
(RM600 added per month at a 5% return)
|Amount of time spent investing||End Balance|
|Expenses-based emergency savings||30 years||RM273,226|
|Salary-based emergency savings||28.75 years||RM244,567|
There is no right answer
It’s important to note that this is not the difference between having more or less money in the long run. It’s about whether you have a financial support network in place for you to take advantage of being able to save.
We know that it’s not easy to build an emergency fund. A survey we ran with PIDM last year showed that only 41% of respondents managed to save 20% or more of their salary. A full 25% simply saved whatever was left at the end of the month.
Even then, of those that managed to save, 37% still have less than one month’s income stashed away.
In other words, it’s not always as easy as building an emergency fund and then going on your merry way. Emergencies happen, expensive things break down, or you accidentally decide to splurge a little too much one day.
You could instead take these two savings targets as extreme ends of a spectrum. You don’t have to stick to one end or the other. You could choose to save for six months’ worth of expenses plus an additional 30%. The guidelines are pretty loose.
You will not go wrong, no matter which amount you choose to save (even if it’s somewhere in the middle). What matters is that you are equipped to deal with financial emergencies.
P.S. Remember to revise your emergency savings every once in a while, as your living expenses change.