Iron reserve is one of the most important aspects in personal finance. In English, I usually come across the term “emergency fund”.
The purpose of an iron reserve is to have enough funds on hand for unexpected expenses. It could be something like fixing a car or anything else. Or, for example, the loss of a job, when a person loses part or all of his income. For such cases, it is this reserve that will cover necessary expenses for some time until the situation improves.
It might occur to someone that it is enough to simply have something aside and be done with it. It is certainly better to have something somewhere than nothing. But even the iron reserve can be set to optimally help meet financial goals.
How to determine the ideal amount of iron reserves?
It is commonly stated that one should have funds in the iron reserve to cover 3-6 months of all expenses. And that without having to reduce your lifestyle. This means that if I normally spend 50 thousand CZK per month, I should have 150-300 thousand on hand. A logical reasoning might be that the more I have on hand, the better. But this is not quite an ideal approach, because unnecessary extra money in the iron reserve loses its potential to earn more money.
On the other hand, I should have enough of them to be able to finance most unexpected expenses without problems. I don’t want to be forced to sell my assets in the event of some trivial problem, which may be at a loss and thus interrupt the process of compound interest.
Anyway, like most things, it’s very individual. For some, 1 month is enough, while others should have a year’s worth of expenses in reserve. It depends on many factors. As a fairly interesting general guide, I like this chart from Brian Feroldi:
According to her, everyone should have at least 1 month aside. Then it depends on whether you support someone else (dependents), in which sector you work (industry) and how many sources of income you have (sources of income). So, for example, a miner who has 4 children at home and a wife on maternity leave should have much more in the iron reserve (up to 10 months) than a childless family of two, who also receives additional income from dividends and an ebook on the topic of programming (1 month is enough) .
We set our iron reserve for 3 months
According to that table above, we should have about 6-7 months in reserve. We have two small children, my wife is on maternity leave, and apart from my income, we have no significant other. But still, it seems pointless to me to aim for such a volume.
As an ideal, I decided to have funds in the iron reserve in the volume of 3 average monthly expenses. The table above is designed by a person from the USA, where they have slightly different conditions on the labor market and in the social system. In reality, we have a much more socialist system here, and therefore there is not so much danger that a person would suddenly lose all income:
- There is little chance that I will lose my income from my hourly job. A person usually gets some notice period (2 months), often also severance pay in the amount of several months’ salary (1-3 months depending on the length of the employment relationship, even more if the employer wishes). So before the iron reserve is reached, I reckon that I would have about 5 months to find an alternative. That is, if there is no serious breach of work duties on my part. At that point, you can be terminated without severance pay. In the US, you can be fired for an hour practically at any time, and tomorrow you are out of work and without income.
- In addition, in the Czech Republic we are not so threatened by some unexpected expenses, which are quite normal in the USA. For example, expenses for hospital treatment. We are all compulsorily insured and thus have “free” health care if needed.
- Even if I don’t find another job during the notice period, there is still the wife’s maternity leave, unemployment support and various additional earnings. Although this will not fully replace the loss of the main income, it will reduce the need to draw full monthly expenses from the reserve. So realistically, even the 3-month reserve will last much longer.
- There is always an opportunity to temporarily humble yourself. Minimize food imports, don’t buy beef steaks, etc. This can be endured for a while.
- By far our highest regular expense is the mortgage. This can be temporarily reduced by tens of percent in the event of a loss of income, or you can even have repayments postponed completely.
For these reasons, I find it unnecessary to have more than 3 months in reserve. At the same time, I don’t want to have less in it, because I always want to have enough funds on hand for unexpected larger expenses.
Iron reserve always takes precedence
If for some reason we draw funds from the iron reserve, it always takes priority to restore it to the full amount before investing. This is something I struggle with quite a bit myself. I would always rather buy securities than send money to the reserve.
But life’s circumstances don’t ask. If the car is repaired for 30,000 and it does not cover the income in the given month, it must come from the iron reserve. I have to top up the 30,000 from other income before I start buying more shares. Although those funds do not actually earn anything in the reserve, that is not their purpose either. Their purpose is so that we can sleep peacefully.
In addition, I regularly revise its amount after a longer period of time. Of course, our average monthly expenses increase over the years due to inflation. So, if at the end of the year I find out that we had expenses 10% higher than the previous year, I also increase the reserve by 10% and do not invest until I have completely filled it.
Where do we have the reserve?
There are 3 criteria that determine where we will have the reserve. And those are liquidity, low risk and reasonable return.
Liquidity
Liquidity means that I have immediate access to money when needed. Products such as term deposits, building savings, etc., where there are different conditions of access to the funds after some time, are thus eliminated. So one cannot get to them when needed, or at least not quickly enough. Such products are more suitable for some research on something specific that we want to buy in the future.
Low risk
I also want to have them somewhere where there is minimal risk of losing them. Whether due to volatility, the failure of the product provider or anything else. This condition excludes securities of all kinds (including bonds), mutual funds, cryptocurrencies, etc.
Reasonable yield
But at the same time, I want to maximize the return on these funds. Which is, of course, contrary to high liquidity and low risk. I mean maximize as much as possible. If you have, for example, 200,000 in the iron reserve, then at an interest rate of 5%, the annual return is 10,000, which is no longer negligible and it can cover, for example, a small repair on our car. So it is out of the question to have a reserve at home in a piggy bank or in a current account.
The winner for me is the savings account
A savings account is the best option for me to have an iron reserve. I don’t know of any other product that fulfills those three conditions better than a classic stove. I can get the money there at any time, currently most banks have an interest rate of around 5% and I am not afraid that a large Czech/European bank would go bankrupt. And even if, the deposits are insured.
After considering all these options, a simple savings account with one of the banks works best for me. But even with a savings account, you need to keep an eye on the terms. Sometimes banks offer a given interest rate as a bonus. You have to fulfill various conditions to reach it. For example, paying x times from a current account at the same bank, or paying only up to a certain amount of deposited funds.
In conclusion
In this article I have revealed how we think about the iron reserve. That is, about how many funds we have on hand for unexpected expenses and where we have them stored. Like most topics, this one is quite individual. We are all different and each of us needs to have a different volume of funds on hand. But one thing is common to all, it is important to actively think about it and try to set it correctly. Not just hoping that I will be lucky and not need the money at the worst moment.
2024-02-18 14:56:50
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