Emergency Fund: An Important Part of Financial Planning
An emergency fund is a part of sound financial planning and is an essential way to protect yourself from financial mishaps. Learn why you need it, how much should you have in it, and how can you start and build a well-funded emergency fund.
What is an Emergency Fund?
An emergency fund is money set aside for unplanned expenses such as car and home repairs, urgent medical procedures and medical bills, job loss, family emergencies, or any other financial emergencies.
Why do I Need an Emergency Fund?
Emergency funds create a financial safety net for times when unforeseen mishaps occur. An emergency reserve of cash will help you get through the difficult times and prevent going astray from the path to your financial security.
Not having an emergency fund may force you to liquidate retirement accounts, investments, or other assets. The need to liquidate investments at the wrong time could mean that you will have to sell at a loss or lose future gains, incur capital gains taxes at the least favorable time, or incur penalties for early withdrawal from your retirement plans. Any of these outcomes may have a lasting impact which may lead to more debt in the future.
It doesn't matter how much money you make or how well you plan things out in life, bad things happen to everyone. Having a well-funded emergency fund will cover your basic living expenses and prevent you from liquidating assets that you are not ready to liquidate.
If you don't have any other assets or savings, relying on credit cards or high-interest loans in case of emergencies may be your only option. Getting into debt during vulnerable times can lead to the debt trap from which it may be difficult or even impossible to get out.
How Much Should I Have in My Emergency Fund?
How much you should save in your emergency fund is of course highly subjective but is not that difficult to figure out. The general rule of thumb is to have between three and six months of basic living expenses. The less consistent your income and the less secure your employment - the more you will want to have in your fund.
Think about the unplanned expenses you have had in the past and how much money you needed to cover them. This may help you estimate how much you want to set aside.
Before You Get Discouraged Because it is Too Much
Don't abandon the idea if you think you will never be able to save three to six months of your expenses. Because any emergency fund is better than absolutely no emergency fund. Even a small amount can provide some financial security. You can start with a few hundred in your fund, which will be extremely handy someday.
And once you reach that goal, you can set up a new one, even if it's just a tiny bit larger. The progress of reaching your goals will encourage you to continue. Eventually, will come the time when the possibility of building a well-funded emergency fund won't seem unreachable. Don't give up.
How to Start and Build an Emergency Fund?
Here are a few strategies to get your fund started. Everyone has a different ability to save and if you cannot use some of these strategies now, pick the ones that will work for your situation. Improving financial health takes time. With time your situation may change, and you will be able to adapt other strategies.
Budget and Manage Your Cash Flow
Budgeting and managing your cash flow are essential ways of staying on top of your finances and preventing overspending. Cash flow is the amount of money that is moving into and out of your pocket at a specific point in time. For example, your cash flow is your monthly income and your expenses and spending. A budget is a spending plan that lets you estimate how much income you need each month to cover all of your expenses.
When you figure out your cash flow - see if it's timed appropriately. By understanding when your money is coming in and going out - you can find opportunities to adjust your spending and savings. For example, you may be able to adjust the due dates for your bills and find periods when you have more money that can be moved into savings.
Be Consistent with Your Contributions
After understanding your cash flow you will have an idea of how much you can contribute towards the goal of building your emergency fund. Commit this amount to save at regular intervals - every paycheck, every month, or every week.
You don't have to be too aggressive with your plan - otherwise, you can put too much strain on your cash flow which can help you rationalize abandoning your plan altogether. It is perfectly fine to set small contributions at first and increase them later when you are sure your routine works. The goal is to have consistent contributions, not a consistent struggle.
Automate Your Emergency Fund Contributions
The best way to ensure your contributions are consistent is to save automatically. Most employers provide direct deposit to more than one account. You can send a portion of your paycheck directly into your emergency fund while keeping the most of it to pay bills. If you never touch your fund money in the first place - it may be the easiest way to save them. It is a "out of sight, out of mind" kind of deal.
If you can't split your check before you get it from your employer, you can set up recurring transfers through your bank and automatically send a fixed amount from your checking to your savings account.
Taking one of these approaches will ensure that you contribute regularly to your emergency fund and you won't use the money for other things.
Watch out for the fees! Be mindful of your cash flow and make sure you have enough for automatic transfers to avoid overdraft fees if there is not enough money in your account. Some banks charge maintenance or monthly fees if the balance in your account is below a certain amount. Don't let any fees eat into your savings.
Lower Your Expenses Wherever You Can
To make sure that you have money to contribute to your fund or to find ways to increase the contribution amounts - create a budget and find all non-essential expenses and see what you can live without. Or at least what you can live with less. Non-essential expenses are usually the expenses that you don't necessarily need. It may be dining out and takeout, a video streaming subscription that you rarely watch, or other entertainment costs.
Reducing and eliminating expenses is one of the fastest ways you can increase your savings.
Don't Spend Your Windfalls
There are times when you get an influx of money. It can be a tax refund, holiday or birthday cash gifts, or an annual bonus at work. These sums of money are often regarded as spending money. But saving all or a portion of that money could help you quickly build up your emergency fund.
Fun fact: Research shows that most people tend to separate money into imaginary categories. For example, there is a hard-earned paycheck and there is free money, such as a birthday gift or a tax return. People are more likely to spend unexpected income on something indulgent or frivolous. It is important to remember that money is always the same no matter where it came from. Any dollar you got is the same as any other and it shouldn't be treated any differently.
Where Should I Keep My Emergency Fund?
Where you put your emergency fund depends on your situation. The fund should be safe and easily accessible in emergencies. But it should not be too easily accessible or mixed with the rest of your money in your regular operating account to help you resist the temptation to spend it on non-emergencies.
You can start with a separate savings account to build the initial part of your emergency fund. And later you can explore other types of low-risk, high liquidity accounts for keeping the rest of your fund to protect it from inflation.
Related: Where to Put Your Emergency Fund
Balancing Debt and Your Emergency Fund?
It's important to save for emergencies, but if you are in the process of paying off high-interest credit cards or loans, every day you're in debt is costing you money. What you are saving for your emergency fund may be canceled out by the interest you have to pay to your creditors. In some cases, it may be best to set a modest goal for your emergency fund and focus on paying out your high-interest debt. Once all that debt is paid off, you can direct your efforts toward building a well-funded emergency fund.
When Should You Use the Money?
Use your emergency savings only for expenses directly related to an emergency that you can't cover with your regular funds. When you draw from your emergency fund, it's important to immediately start replenishing it.