We have already discussed about the basics of financial planning. One of the key component of any sound financial plan is having substantial amount of saving as emergency fund. An emergency fund is an absolute necessity.
We’ve all been through unforeseen financial emergencies—an unexpected medical bill, a broken appliance, a loss of income, or even a damaged cell phone. Large or small, these unplanned expenses often feel like they hit at the worst times.
The coronavirus pandemic has proved the necessity of having an emergency fund when crisis hits.
What is an Emergency Fund?
An emergency fund is a cash reserve that’s specifically set aside for unplanned expenses or financial emergencies. Some examples include car repairs, home repairs, medical bills, or a loss of income.
It’s purpose is to improve financial security by creating a safety net that can be used to meet unanticipated expenses.
Understanding Emergency Funds
You create an emergency fund when you put away money that is intended to be used during times of financial hardship.
The size for an emergency fund depends on a number of factors, including your income, financial situation, expenses, lifestyle, and debts. Many financial advisors recommend saving enough to cover anywhere from three to six months’ worth of expenses, which can help you weather a modest healthcare bill or a short bout of unemployment.
However, some experts suggests an emergency fund that can handle up to eight months’ worth of outlays. This turned out to be true during the 2020 crisis, a stark reminder of how sudden and deep an economic slump can be.
The saving levels depends upon individual circumstances with which you’re comfortable. For example, a single individual without children may be comfortable covering three months of expenses, while the sole breadwinner for an entire family may want to cover half a year or more.
If you’re living paycheck to paycheck, you may start with more modest goals, such as putting aside 1-2% of your net income into a rainy day fund and slowly increasing your contribution rate every few months.
Even a modest safety net can help buy you a little time should you face an unforeseen financial crisis. It’s one of the first steps you can take to start saving. By putting money aside—even a small amount—for these unplanned expenses, you’re able to recover quicker and get back on track towards reaching your larger savings goals.
Your emergency fund is like an insurance policy. Once you have it, guard it carefully. You should not be using it for incidental expenses. In fact, as your salary rises, be sure to up the amount to match your new situation.
Use the fund only in the event of an emergency and spend it carefully when you do need to draw on it. Remember, once that money is spent, it always takes much longer than anticipated to replace it. Start now and save whatever you can, even if it isn’t much. Having an emergency fund gives you a better shot at weathering a crisis without running up a credit card balance or taking out a personal loan.
What is an emergency fund for?
As simple as the answer seems, it is important to make sure that you can distinguish between what is an emergency and what isn’t. An emergency is an unexpected bill that you can’t pay—not money to go to a movie or for some other nonessential expense.
How much should I have in an Emergency Fund? And why?
The amount varies according to your living expenses, but the general rule of thumb is to eventually save six months to eight months of living expenses.
Approach this the same way you would approach any other financial goal. Put together a plan and execute it.
The first step is to determine how much you spend each month. Housing, transportation, and food will likely be the categories that eat up most of your cash.
Once you know your total expenses for each month, multiply that number by three. Reaching that number will be your initial goal. To achieve your three-month target, you need to start saving money.
The amount of money required to have in a proper emergency fund is certainly significant, but we do live in uncertain times with uncertain economies.
Also, unemployment can happen unexpectedly, usually at the worst possible moment. Emergencies such as sudden illness or disability, major car repairs can be expensive, and there’s never a good time for these things to happen.
How to build an Emergency Fund?
Like all savings, starting early is the key to setting up an emergency fund, because it helps you build up a comfortable cushion against unexpected emergencies in life.
Getting a start on emergency funds is relatively easy. Here are simple ways to begin saving for one.
- Save consistently
Building a sizeable saving is easier when you’re able to consistently put money away. It’s also one of the fastest ways to see it grow.
- Set aside a certain amount from your salary each month.
Calculate your living expenses for the desired period, and make that your target amount for an emergency fund. You can then divert a fixed portion of your pay check to that account each month.
Save your tax refund.
Consider diverting your tax refund or bonus toward your emergency fund to give you an added financial cushion.
Emergency fund are usually parked in assets that are highly liquid. This reduces the need to either draw from high-interest debt options, such as credit cards or loans, or compromise your future security by tapping into retirement funds.
You want to make sure this fund is safe, accessible, and in a place where you’re not tempted to spend it on non-emergencies.
Money market funds and high-interest savings accounts are two good places to park your emergency fund.
These choices make it harder for you to dip into it and you’ll also earn a bit of return on the money.
When do I use it?
You need to set some guidelines for yourself, if married, then for your spouse also as to what constitutes an emergency expense. Not every unexpected expense needs you to dip into your hard build reserves.
Having a reserve fund for unexpected financial shocks can help you avoid relying on other forms of credit or loans that can turn into major debt.
However, don’t be afraid to use it if you need it. If you have spent down your emergency savings, just work to build it up again. Practicing your savings skills over time will make this easier.
You probably want to park your emergency fund in a vehicle that can be easily liquidated should a financial need suddenly arise. While storing cash in a savings account may be the safest approach, there are other relatively secure ways to store a part of your emergency fund that offer greater interest-earning potential. An example would be high-interest savings accounts. You’ll have the access you need in an emergency but won’t be incurring fees and time delays associated with other vehicles.
The Bottom Line
Having a dedicated savings or emergency fund is one essential way to protect yourself. It helps you gain control over finances and provide peace of mind.