Emergencies are unpleasant occurrences that could derail one's financial stability, especially when unprepared or planned for. Emergencies like a fender bender, an unexpected illness, a damaged cell phone, a broken appliance, or even job loss often come with a financial challenge that tends to hit at the worst times.
While emergencies are often out of our control, having savings or emergency funds can help cushion the financial implications of dealing with these unexpected events.
What is an Emergency Fund?
An emergency fund is a money reserved to meet or offset the expense of an unexpected situation. It is a safety net to prevent you from falling into debt or making hasty financial decisions when faced with unforeseen challenges. An emergency fund is not a long-term saving or investment set aside for a plan like a new car, tuition, vacation or routine expense; it is simply a pool of money reserved for emergencies. These funds help cushion the financial shocks that often accompany emergencies.
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Why Do I Need an Emergency Fund?
Without savings, even minor financial shocks could set you back and quickly turn into a debt that can cause a lasting impact. Primarily, the following are reasons for having an emergency fund:
1. Financial Security
An emergency fund provides a sense of financial security during difficult times. It ensures that you have the means to handle unexpected expenses without jeopardising your overall financial stability.
2. Peace of Mind
Being aware that you have a financial safety net can alleviate stress and anxiety. You can navigate through emergencies with a clearer mind, as you won't solely depend on credit cards, loans, or borrowing from friends and family.
3. Preventing Debt
Relying on loans or credit cards to cover emergencies can lead to debt accumulation and high-interest payments. An emergency fund helps you avoid debt and its associated financial burdens.
4. Flexibility and Freedom
With an emergency fund, you can address unexpected situations on your terms. You won't have to make rushed decisions or compromise your financial goals.
How Much Should I Save?
Since there's no way of knowing what type of emergencies one would face, it becomes difficult to ascertain the size of emergency funds one should have. However, on a general note, the amount of your emergency savings fund depends on your situation. For instance, a person with an unstable job and a sizeable dependent family would need a larger emergency fund than one who is single and makes enough to cover all household bills. Being in an unsteady financial situation or having so many people depending on you financially can drive up the amount you'll want to have saved away.
Several financial experts recommend having three to six months' worth of emergency savings tucked away, based on your monthly living costs, including housing, feeding, transportation, insurance, and personal expenses.
How to Build and Maintain My Emergency Fund
To build and maintain an emergency fund, start by setting a target for your emergency fund. Several experts recommend saving three to six months' worth of living expenses. This amount can vary based on your circumstances, such as job stability and family responsibilities.
1. Create a Separate Account
To prevent the temptation of dipping into your emergency fund for non-urgent expenses, open a separate savings account dedicated solely to this purpose.
2. Consistent Contributions
Establish a regular savings plan and contribute a percentage of your earnings to your emergency fund. Treat it as a non-negotiable expense.
3. Windfalls and Bonuses
Consider allocating windfalls, such as tax refunds or work bonuses, to your emergency fund to accelerate its growth.
4. Make your savings automatic
Putting money aside can feel challenging, but saving automatically is an easy way to save consistently and see it build over time. A common way to do this is to set up recurring transfers through your bank so funds are moved automatically from your checking account to your savings account. Decide how much to transfer and how often, then set it up to make consistent contributions to your savings.
However, it's advisable to be mindful of your balances to avoid overdraft fees if there isn't enough money in your checking account during the automatic transaction. To help you remember, consider setting up automatic notifications to check your balance.
5. Reevaluate Periodically
As your financial situation evolves, periodically reassess your emergency fund goal. Adjust the target amount if necessary, considering changes in living expenses, income, and responsibilities.
6. Celebrate your successes
If you're consistent with your savings habit, don't miss the opportunity to recognise your accomplishments. Find a few ways to treat yourself, and if you've reached your goal, set your next one.
Where To Save It
Your emergency fund should be separate from your checking account to avoid the temptation of spending the money on non-emergencies.
It should also be kept in a safe and easily accessible place in case of an emergency — and it should be safe from depreciating loss. It would be unwise to invest your emergency fund in risky assets to earn higher returns. This money isn't an investment — it's a safety net.
Emergency funds are best placed in an interest-bearing bank account that can easily be accessed without taxes or penalties. The issue associated with putting your emergency funds into mutual funds, stocks, or alternative investments is the potential for their value to decline if quick access to the funds becomes necessary. It is advisable to keep your emergency savings in a readily available account to prevent incurring early withdrawal fees.
Alternatively, emergency funds can be kept on prepaid cards. A prepaid card isn't connected to a bank or credit union, and you're limited to spending only the sum on your card.
Another option is to save the emergency funds in cash at home or with a trusted family member or friend. Remember that cash can easily be stolen, lost, or destroyed.
When Should I Use My Emergency Saving
To answer this question, first set guidelines on what constitutes an emergency or unplanned expense. If the expense isn't unexpected and necessary and can wait, it should not be paid for with emergency savings.
However, don't be afraid to use it if you need it. If you spend down what's in your emergency savings, work to build it up again. Practising your savings skills over time will make this easier.
Conclusion
Emergency funds are a critical component of a healthy financial plan, providing you with the confidence and resilience to tackle life's unexpected challenges. It empowers you to control your finances and prevents emergencies from derailing your long-term goals. By diligently building and maintaining an emergency fund, you can ensure you're prepared for whatever curveballs life throws. Remember, it's not a matter of if an emergency will happen, but when – and having an emergency fund can make all the difference.