It is a good idea to save several months salary in a rainy day fund. But how much money should you save? Should you save more during a recession?

Why Do You Need a Rainy Day Fund?

A rainy day fund usually serves several purposes:

1. It replaces income in the event of a job loss while you look for a new job.
2. In the event of a catastrophic injury or illness, it provides you with cash for unanticipated expenses not covered by insurance.
3. If you suffer a major casualty loss, such as your home burning down and you lose everything, it gives you enough cash to pay for day-to-day expenses until the insurance company pays you for your loss.
4. To post a bond in case of an arrest.

The rainy day fund should only be used for emergencies. An emergency is a critical problem that happens once in a blue moon, not every week. A craving for chocolate or being a little short at the end of the month is not sufficient justification to raid the rainy day fund. Otherwise the rainy day fund might not be there when you really need it.

The Rainy Day Fund Must be Liquid

As a result the rainy day fund needs to be liquid enough to provide same-day access to the money. Examples include cash and bank savings accounts.  Stocks, bonds and mutual funds do not provide adequate liquidity since you can't sell the investments on weekends and it may take a few days to settle a trade. (Also, some investments are thinly traded and may force you to take a large loss if you need to sell them in a hurry.)  Examples of non-liquid assets include bank certificates of deposit (CD), retirement plans (e.g., a 401(k) or IRA), cars and real estate. Though in a pinch you could make a withdrawal from a CD by paying an early redemption penalty. Usually this means forfeiting three months of interest.

A good strategy is to keep some money in cash, some in a savings account, and to stagger the maturity dates on a set of CDs so that there is always a CD maturing every three months.

The money should be invested in conservative investments with minimal risk to principal so that the amount of money in the rainy day fund will be relatively stable.

Some people use their checking account as a rainy day fund. This is a risky approach since the checking account balance will shrink between paychecks, and most people do not have the discipline necessary to resist spending money that is too available. A rainy day fund should be in a separate account so that you have to make at least a little effort to withdraw the funds. Otherwise you may be tempted to spend the money on wants, not needs.

How Many Months Should You Have in the Rainy Day Fund?

The rainy day fund should be large enough to replace your income for as long as it takes to find a new job.

According to the Labor Force Statistics from the Current Population Survey of the US Bureau of Labor Statistics the average number of weeks unemployed by month from 1948 to 2009 ranged from a low of 7.1 weeks in September 1953 to a high of 21.2 weeks in July 1983. Since 1999 the average number of weeks unemployed ranged from a low of 12.1 weeks in May 2001 to a high of 20.5 weeks in June 2004. Those figures are consistent with a rainy day fund of 3 to 6 months if one adds a month to the peak number of weeks unemployed.

The median number of weeks unemployed is typically about half the average number of weeks unemployed.

In March 2009 the average number of weeks unemployed was 20.1 weeks. The average number of weeks unemployed is a trailing indicator, so it is likely that this figure will increase.  If the current recession follows a typical pattern, the average number of weeks unemployed will reach a peak of at most 23.2 weeks by December 2009 or January 2010. If one adds a month to the peak number of weeks unemployed, that would suggest allowing for a rainy day fund of up to 7 months. If you want to be really cautious, you could allow for 8 or 9 months in the rainy day fund, yielding a 6-9 months rule of thumb instead of 3-6 months.

Even if the average number of weeks unemployed were greater, it would not be necessary to keep that much money in liquid form. You also don't want to have too large a rainy day fund, as that would take money away from investments with a greater return potential.  You can always sell stocks, bonds and mutual funds in a pinch to supplement the rainy day fund. You don't want the timing of the decision to sell some of your investments to be dictated by a desperate need to pay bills. Emergencies are always unanticipated and come at a most inopportune time. However, 3-6 months is more than enough time to give you the flexibility to sell your investments when the return is at a peak. After all, one normally rebalances a portfolio at least once a year, sometimes quarterly, and that involves selling assets that have appreciated.

How Much Money Should You Allow Per Month?

The simplest rule of thumb is to use your salary as a yardstick for the amount of money to keep in the rainy day fund. Thus the rule of thumb to save 3-6 months of take-home pay in the rainy day fund.

Another approach is to calculate your typical monthly basic living expenses, such as food, housing (rent or mortgage), utilities, transportation (auto payments and gas), medical and pharmacy bills, insurance, taxes and tuition. Don't forget to include an allowance for job-hunting expenses, such as phone, internet and photocopying.  The idea is to focus only on mandatory expenses, not discretionary expenses.

A third approach is to use the Poverty Line, which is about $1,000 a month for a family of 1 and about $2,000 a month for a family of 4. The poverty line is considered to be the income level below which a family has absolutely no choice how they spend their money. Of course, the cost of living may vary considerably depending on where you live, but the poverty line establishes a bare minimum.

Pay Off Credit Card Debt First

Should you pay down debt first or build a rainy day fund first? What should the initial amount be?

If you have a lot of credit card debt, maintain a one-month emergency fund until you are no longer in debt. This means at least $1,000 if you are single and $2,000 if you have a family. (At least $500 should be in cash and at least $500 should be in a bank savings account.) The goal is to have just enough money to deal with medium-sized emergencies. A major catastrophe will wipe you out regardless.

Credit card debt is very expensive. Paying off that debt first will make it easier for you to build a larger rainy day fund. If you try building a rainy day fund first, you will just be digging yourself into a deeper hole. Carrying a balance on your credit cards is a sign that you're living beyond your means, so you need to address your spending habits first. Living paycheck to paycheck puts you at great risk of even a minor emergency causing a crisis, so you need to get your finances in order first. Paying down debt should have at least equal if not greater priority than building a larger rainy day fund.
 
On the other hand, some people argue that the risk of job loss is greater during a recession, so a greater priority should be placed on building a rainy day fund. Either way you should cut spending so that you have more money to save in a rainy day fund or use to pay down debt. Cutting your spending now will also make it easier for you to manage your finances if you happen to lose your job.

Other Considations

Maintaining a large rainy day fund is less critical if you are married and both you and your spouse work. Unless you both work for the same company, you are unlikely to lose both your jobs at the same time. So it is reasonable to base the rainy day fund on the higher income. But if you can, build a rainy day fund that could replace both of your salaries if necessary. Having more savings is always better.

In an emergency credit cards can be used to pay medical bills and buy food. On the other hand, credit card issuers have been reducing credit limits on borrowers who are at greater risk of default, so you can't necessarily count on being able to use a credit card in an emergency. However, borrowers who pay their credit card bills on time, who pay more than the minimum amount due, and who are making progress in paying down their debt are less likely to experience a reduction in their credit limits.

You should maintain adequate health insurance and property insurance (renter's insurance or homeowner's insurance), enough to cover catastrophic problems. If you are married or you have dependents other than a spouse, you should also carry enough term life insurance to replace your income. You should also maintain short- and long-term diability insurance.