Here's why you need to build an emergency fund
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Although we never foresee losing our jobs or find ourselves a medical emergency, and may never be entirely ready emotionally, there are ways to prepare financially for these surprises.
In an emergency, you have enough to worry about-- money shouldn’t be one of those things.
Having a credit card ready isn’t an emergency plan. Neither is taking out a loan from your bank.
An emergency fund gives you the peace of mind to know that you’ll be able to afford and handle emergencies in a way that doesn’t compromise your finances and quality of life.
Here are some common questions answered about how to build an emergency fund.
How much money should be in my emergency fund?
Emergencies can range from $200 for stitches at the hospital, to thousands of dollars to replace a refrigerator. Your emergency fund should be able to cover the wide range of emergencies that could come your way.
Having a liquid fund for immediate use, such as needing to pay for an emergency hospital visit, will give you the ability to pay anything off right then and there, not having to worry about loans in the future. You should have in this liquid account, such as a checking account, about 3 months’ worth of expenses.
Having a larger, second emergency fund will provide you the means and peace of mind to pay for a larger event, such as losing your job. This longer-term emergency fund should be between 6 and 9 months’ worth of expenses. It should be in a liquid, low-risk investment product that earns you some returns, but that also gives you easy access to your own money should you need it.
Having almost a year’s worth of expenses seems like a lot, but this setup ensures that you’ll be ready for just about anything that could come your way.
Where should I keep my emergency fund?
Not under your mattress.
Most importantly, your emergency fund needs to be liquid. Put your “immediate-emergencies” fund in a checking or savings account so that you can access it immediately.
A savings account was once a sufficient place for an emergency fund due to its high liquidity. Now, with such low interest rates, savings accounts aren’t the most attractive places to put your money if you want to grow the value of your money beyond just the rate of inflation.
There are investment options that let you access your money almost just as easily and as quickly as with a savings account. Put your larger fund that covers 6 to 9 months of expenses in an investment fund. This investment fund, most importantly, should let you withdraw the funds easily while it continues to grow with market returns until you need it.
Look for investment products and plans that have immediate or very quick liquidity (withdrawals) at no cost, have low risk, and are separate from a debit account so that you aren’t tempted to spend it on non-emergencies.
How do I build an emergency fund?
Now you know how much money you should have and where to put it. But how do you maximise its value when it’s sitting there waiting to save a rainy day?
Unlike other savings plans that probably have longer time horizons, emergency funds need to be built as early as possible, as you never know when you may need unexpected cash.
Build your emergency fund before investing in other financial objectives. Sure, saving for the downpayment of your first home sounds much more exciting than saving for an emergency fund that (hopefully) just sits there. But it’s best to protect you and your family with a safety net as early as possible.
To build your emergency funds, start by first assessing the amount of cash that you currently have and with which you can contribute to the funds.
Build the short-term fund first, by either putting aside cash you already have, or making a monthly savings plan that helps you reach the fund target as soon as possible. You may need to cut back on some of your weekend spending for a few months to get there, but it’s worth it.
Now that you've built your short-term emergency fund, you can start investing into a low-cost, low-risk, liquid investment plan, for your 6-9 months emergency fund.
Any additional cash you have that doesn’t go towards your daily living expenses can be used as an initial lump sum so that you can accrue more interest and returns on top of the monthly deposit plan you’ll need to implement.
Try to reach your emergency fund target with a few large monthly deposits, that could be a simple way to build your fund. Again, you might need to cut back on some spending to get this fund together.
Think about it: if you can only put aside $100 a month, for example, it will take you years to build your emergency fund.
This urgency is important to understand when you are planning out your monthly savings plan.
If you can’t put aside larger amounts each month due to income and expense restrictions, do you need to make broader lifestyle changes? Could you be paying less for rent so you can put more money into your future?
These lifestyle changes can help you build your emergency fund (and other investment funds!) more quickly so that you’re prepared for whatever life throws your way.
I have insurance. Do I still need an emergency fund?
Insurance policies are great, but they are a hedge, not an emergency fund. You should have an insurance policy that covers some of these emergencies (e.g health and medical insurance) to beef up your financial health.
While insurance does cover a wide range of emergencies, it does take time for the claims to be processed. Hence, having an emergency fund to pay initial bills before your insurance policy reimburses you is still crucial.
What happens when I deplete my emergency fund?
If you deplete your emergency fund, rebuild it as soon as you can, even if that means putting aside contributions to other investments.
Hopefully, you’ve been putting money towards other goals, such as buying a house. Those savings should be temporarily redirected to rebuild your emergency fund back to its target amount.
Then, once it’s back to its 3 or 6 month expenses amount, go ahead and start investing in those other goals again.
Having a monthly savings plan helps you get closer to your personal goals while also making sure you have enough to cover life’s surprises.