Based On Expenses Or Salary?
By now, you’ve probably heard that you need an emergency savings stock that can last at least six months. It is common for you to be told that he should be able to support you during this period if you lose your job, and therefore based on your monthly expenses.
On the other hand, a lot can happen over a six month period; and having savings that cover only basic expenses may not be enough to deal with unforeseen emergencies.
So, should your emergency savings be based on your total salary?
Expenses based: Faster to reach, less flexible in an emergency, may allocate resources for other investments
Based on salary: Takes more time to do, better equipped to deal with unforeseen expenses, can lose investment opportunities
How long does it take to save?
Before going into detail, we must first establish that your decision must be based on your own situation. Each option has its own set of opportunity costs and benefits. It’s really up to you how you want to go about it.
Here is an example of how the two options break down. We will assume a person with an income of RM3,000 after deductions. Suppose this person follows the 50/30/20 budgeting rule.
|Expense-based||Based on salary|
|Expenses (50% of salary)||RM1,500||RM1,500|
|Monthly savings (20% of monthly income)||RM600||RM600|
|It’s time to reach the goal with 20% savings||15 months||30 months|
|Monthly savings (50% of monthly income)||RM1500||RM1500|
|It’s time to hit the target with 50% savings||6 months||12 months|
The table offers two different options depending on the aggressiveness of your savings. After all, the idea was to allow 30% of your salary for discretionary spending; after all, you are not a savage. However, the table also shows how much you can reach your goal faster if you can save more 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 may even need these additional savings.
Well, the idea is that you may want to create a much larger savings buffer to accommodate larger issues. You cannot be unemployed for six months at a time; but if you do, then you’d better hope nothing goes wrong during this time.
This means that your emergency savings can only cover your living expenses and does not account for anything that needs to be replaced or broken down. So you would pray that your car would keep running and that you wouldn’t drop your phone.
This is why you may want a little extra squirrel in case something goes 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 opt for the expense-based savings option).
In other words, it is the option for people who want a bigger financial buffer.
And base it on spending?
Why would you opt for less emergency savings? Well, it could be because you are in an industry that offers many job opportunities and you have an insurance policy that protects you if you lose the ability to work.
If you do, then additional savings can – and should – be invested in investments for passive income generation. The short-term difference is not large. Assuming you invest at a conservative return of 5% per year, you could potentially earn an additional RM261 compared to simply saving everything (based on a saving of RM600 per month described in the table above) .
However, assuming you have a 30-year investment plan – at the same rate of return – the numbers look very different.
(RM600 added per month with a yield of 5%)
|Time spent investing||Final sale|
|Spend-based emergency savings||30 years||RM273,226|
|Salary-based emergency savings||28.75 years||RM244,567|
There is no correct answer
It is important to note that this is not the difference between having more or less money in the long run. The question is whether you have a financial support network in place to allow you to take advantage of savings.
We know it is not easy to build an emergency fund. A survey we conducted with PIDM last year found that only 41% of respondents were able to save 20% or more of their wages. A total of 25% simply saved all that was left at the end of the month.
Even then, among those who have managed to save, 37% still have less than a month of hidden income.
In other words, it’s not always as easy as setting up an emergency fund and continuing your happy journey. Emergencies happen, expensive things break down, or you accidentally decide to splurge too much one day.
You could rather take these two savings targets as the extreme ends of a spectrum. You don’t have to stick to one end or the other. You can choose to save for six months of spending plus an additional 30%. The directives are quite loose.
You won’t go wrong no matter how much you choose to save (even if it’s somewhere in the middle). What matters is that you are equipped to deal with financial emergencies.
PS Remember to revise your emergency savings from time to time as your living expenses change.
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