What is an Emergency Fund?
An emergency fund is exactly what it sounds like: a fund for an emergency! This is the amount of money you set aside apart from your savings account to take care of any unforeseen expenses.
Examples of emergencies and surprise expenditure include job loss, car breakdown, an urgent visit to a veterinarian, relocating to another city, household repairs etc.
Every now and then you come across such unforeseen situations. An emergency fund helps you overcome these expenses without leaving a dent on your savings and investments.
How much emergency fund should I have?
The most commonly asked question about an emergency fund is “how much emergency fund should I have”? The answer is not as simple as it depends on a lot of factors.
Ideally, an emergency fund must be able to support you and your family for the next 3 to 6 months in case of emergency. However, the composition of an emergency fund can vary from person to person.
Some people believe they have a secure job and they do not need more than a bare minimum amount in their fund, but on the other hand, some people live their life paycheck-to-paycheck even a small medical expense can affect the whole budget for coming few months.
I have compiled a list of factors one must consider before starting an emergency fund, find the perfect match for yourself (based on your financial and geographical conditions) to figure out the size of your emergency fund.
4 Factors to Consider Before Investing in an Emergency Fund:
- Job Security: Depending on how secure your job is, you must plan your emergency fund. If you have a secure job you can easily manage with a fund that would cover 3 months of your expenses.
- Considering you have other forms of investments and savings which you can utilize if need be.
- If you don’t have job security, you must have a fund of at least 3-6 months of living expenses. In case of a recession, such a fund can help you survive the worst until you find a job.
- Joblessness might also induce other expenses like re-locating expenses and opportunity costs. Some people might end up in a low paying job or some might even have to relocate to places with more job opportunities.
- 2. Accident/Theft/Other Miscellaneous Expenses: Depending on your locality and neighborhood you must plan your fund. You don’t need to add contingency money for theft if the neighborhood is safe.
- It is highly recommended that you keep your vehicles insured, but some people prefer to use their car on basic insurance which does not cover damage coverage. In those cases, even a small accident can add up to your expenses!
- Miscellaneous expenses could include anything, from getting your fence remade after a windstorm to taking your dog to a veterinarian on an emergency visit.
- Depending on your family size, locality, medical conditions you must plan your emergency fund that should cover your expenses without leaving a mark on your savings.
3. Demography/Natural Calamity: your place of residence plays an important role in deciding the size of your emergency fund. If you live in an area that is prone to a natural calamity you should always keep extra money in your emergency fund.
The best way to be prepared for any sort of natural disaster be it an earthquake, windstorm, snowstorm, volcano eruption, wildfire, hurricanes etc is to keep a pile of cash hidden somewhere in your house.
A cash amount of $400-$1000 dollars will help you survive for a few days in case of extreme conditions.
- 4. Credit Limit: Banks and credit companies have made our life easier.
- Depending on your credit limit you can decide the size of your fund.
- People with a higher credit limit can utilize their credit cards in case of an emergency.
- This method is convenient, but it might disturb your budget depending on the interest rates and monthly payments on your credit.
- Now that the emergency fund is set up, it is up to you what you want to do with it.
Where to put emergency fund?
1. Putting in Savings Accounts/Getting Bank Bonuses: The choice of keeping your emergency fund completely liquid (cash) or partially liquid is yours. Some people prefer to use their emergency fund to make more money for them.
Opening a term deposit or tangerine savings account offers a higher rate of interest. This is the best way to fight inflation while keeping your money in a savings account.
Another (a bit more time consuming) way is to distribute your fund into multiple bank accounts and collect bonuses by meeting their requirements.
Certain banks offer cash bonus on savings/checking accounts by maintaining a minimum balance for a particular period of time.
This is an easy way to make extra cash just by opening minimum balance accounts. This also helps improve your credit history.
- 2. Investing in Equity/Other Liquid Assets: Some people are of the opinion that putting money in a savings account is like missing on an opportunity to make money.
- Those people prefer to invest some part of their emergency fund in equities, stocks, and other electronically traded assets. This strategy makes sense if you know what you are doing.
- Staying updated with the market and keeping an eye on your portfolio will help you multiply your money but being clumsy about your investments can cause you a huge loss.
- Even though the money invested is not as liquid as keeping it in a savings account, but you can easily convert your assets into cash as these instruments are highly liquid.
- Utilizing your funds and not letting them sit idle is always the best strategy but many would argue the same for emergency funds.
- Majority of the millennials did not face the wrath of the 2008 market crash, so they are not aware of the importance of emergency funds.
- During a recession or in a natural disaster, your emergency fund in the form of cash and bank savings would be your savior.
- S&P 500 came down 56% during the market crash of 2008, imagine losing half of your emergency fund in an incident that could trigger an emergency (joblessness).
- The decision on how big the fund should be lies in your hands, ideally it should be able to cover your living expenses for 3-6 months. Considering the factors above, decide size and start saving for it.
- It is never too late to prepare for an emergency until it is too late!