Doesn’t expecting the unexpected make the unexpected expected?Bob Dylan
I have mentioned the term “Emergency Fund” in some of my previous posts, so now I will elaborate more on this concept and why it is fundamental to creating financial stability. In this article I will go more into depth about the ins and outs of an emergency fund.
What is an emergency fund?
Let’s first look at what an emergency fund actually is. It is an account that holds liquid funds, other than your savings account, which is to be used whenever unexpected costs occur. Liquid meaning quick and easy to access.
Some examples of these unexpected costs might include medical bills, a car breakdown and repairs for or replacement of various technologies like your phone, laptop or dishwasher perhaps. An emergency fund is also a great buffer may you suddenly loose your job for whatever reason, and still have monthly expenses to cover.
The key words are that it is a funding other than your savings and that it should be able to cover rather large unexpected expenses. So you can see why a financial buffer is critical to have. It will decrease your stress level should any of these unexpected costs arise. It should also be one of the first things you should be setting up when you want to achieve financial stability. It is to be done before you start investing or buy a house.
Some eye-opening statistics
According to CNBC, only 41% of Americans will be able to cover an emergency expense of $1,000. And they do this by dipping into their savings. The other 59% would finance an expense like this by using their credit card, taking out a loan, ask their family and friends for help, or simply have no idea how they will cover a $1,000 emergency expense.
I think these numbers clearly show that most people are not prepared for emergencies, because even dipping into your savings should not be the solution (unless they categorized an emergency fund as savings in this research). Furthermore, CNBC also mentions that the average cost of emergencies for those that took part in the survey, is $3,500.
That is a lot of money to fund with your credit card or to borrow from friends and family. Even worse if you would take a loan out for an expense like that if you consider the interest that you will be paying as well. I bet these numbers will not be much different in many other countries.
Calculating & building your fund
Since an emergency fund is meant to cover rather large costs, it will take some commitment to build one. Generally your emergency fund should equal 6 to 12 months of your monthly salary. Ultimately the number depends on the size of your paycheck, your monthly expenses and your lifestyle.
Some other factors to consider when deciding the size of your fund is your job or the industry that you are working in. If you do not have a stable job, or the industry that you work in is unstable, you might want to have a bigger fund. Another reason to have a bigger fund is when you are working as a freelancer or if there is a lay out or an (unpaid) furlough around the corner.
If building an emergency fund that equals 6 to 12 months of your salary seems impossible, you can also aim for a fund that equals 6 to 12 months worth of living expenses. Just keep in mind that a financial buffer of this size is only limited, whereas one that equals your salary gives more room and certainty.
If you do decide to have an emergency fund that corresponds with your living expenses, you should include the following in your calculation: housing, health care, groceries, utilities, transportation costs and debt. Generally, things like entertainment, vacations, eating out, savings or any luxuries for that matter are not included in the calculation.
Assuming you aim to build a fund that will correspond with your salary, bear in mind that this takes time and most likely requires some extra sacrifices.
Storing your fund
The last thing you should know is where to keep all the money you have collected over time. As mentioned in the beginning of this article, they are liquid funds, meaning “quick and easy access”. Considering this, it is possible to leave your money in a savings account. It is easily accessible, but the downside of a savings account is that your money will become subject to inflation when you ‘park’ it here and thus will become less valuable over the next years.
Putting your money in a long-term investment is also not your best pick. You can never be sure if you will need the money in the near future or not, and when placed in a long-term asset, it will be much harder to access your money. Moreover, a long-term investment generally becomes profitable over a longer period of time. Therefore, the risk of losing money in the short-term increases.
The best option would be to invest your money in a short-term certificate of deposit (CDs) that has a higher interest rate than your typical savings account or in a money market account that grants easy access. Both options will help you compete with inflation.
An emergency fund is an account that is easily accessible and holds funds ought to be used in case of emergencies. The size of your financial buffer should equal 6 to 12 months of your paycheck and thus should be big enough to cover rather large unexpected costs. An emergency fund should not be devalued by inflation and thus should be stored in an interest bearing, short-term investment account.
Lots of love,