Question

Calculating the Cost of Life’s Financial Journey

Neal recently graduated from college. He’s employed by a space exploration company and makes approximately $65,000 per year. His primary goal is to begin saving for an emergency fund. After looking at his budget, Neal has determined that in the case of a severe emergency, he will need to replace 45% of his annual income. This is a conservative estimate, but Neal believes the amount should be sufficient to pay his rent, car payment, food, utility, and insurance expenses.

a. How much income does Neal believe he needs in the case of a severe emergency?

b. After discussing his alternatives with you, assume Neal concludes that he can meet all his necessary expenses with as little as $29,000 per year. If his goal is to establish a 6-month emergency fund, how much should he have on hand today? What will he need if he has a 3-month emergency fund goal?

c. If Neal can save $300 per month toward his emergency fund goal, how long it will it take for him to obtain 3 and 6 months of needed expenses, assuming he can earn a 2% rate of return on his savings?

d. What type of assets would be appropriate for his emergency fund?

e. Today, Neal has few assets that he can use to pay emergency expenses. Until he saves enough for an emergency fund, what other options does he have for funding a potential emergency?

Answer 1

a. Neal believes he needs to replace 45% of his annual income in the case of a severe emergency. Therefore, the amount of income he needs is:

0.45 x $65,000 = $29,250

b. If Neal's goal is to establish a 6-month emergency fund with $29,000 per year in necessary expenses, he would need to have on hand:

6 months x $29,000/12 months = $14,500

If his goal is a 3-month emergency fund, he would need to have on hand:

3 months x $29,000/12 months = $7,250

c. If Neal can save $300 per month toward his emergency fund goal and earn a 2% rate of return on his savings, we can use the formula for the future value of an annuity to determine how long it will take him to save enough for a 3-month and 6-month emergency fund:

FV = PMT x [(1 + r)^n - 1]/r

where FV is the future value, PMT is the monthly payment, r is the monthly interest rate, and n is the number of months.

For a 6-month emergency fund:

FV = $14,500
PMT = $300
r = 0.02/12
n = ?

Solving for n, we get:

n = log[(FV x r/PMT) + 1]/log(1 + r)
n = log[(14,500 x 0.02/12/300) + 1]/log(1 + 0.02/12)
n ≈ 31.8 months

Therefore, it will take Neal approximately 32 months to save enough for a 6-month emergency fund.

For a 3-month emergency fund:

FV = $7,250
PMT = $300
r = 0.02/12
n = ?

Solving for n, we get:

n = log[(FV x r/PMT) + 1]/log(1 + r)
n = log[(7,250 x 0.02/12/300) + 1]/log(1 + 0.02/12)
n ≈ 16 months

Therefore, it will take Neal approximately 16 months to save enough for a 3-month emergency fund.

d. The appropriate assets for an emergency fund are those that are low-risk, liquid, and easily accessible. Examples include savings accounts, money market accounts, and short-term certificates of deposit (CDs).

e. Until Neal saves enough for an emergency fund, he can consider other options for funding a potential emergency, such as taking out a personal loan or using a credit card. However, these options should be used as a last resort, as they can lead to high interest rates and debt. Neal should focus on building his emergency fund as soon as possible to avoid relying on these options in the future.