The concept of emergency funds or reserve funds is a common one in the world of personal finance. The importance of such funds cannot be over-emphasized for every individual who takes their finances seriously.
Vanguard.com defines emergency fund as “a stash of money set aside to cover the financial surprises life throws your way. These unexpected events can be stressful and costly.” According to Investopedia, “An emergency fund is a source of ready cash in case of an unplanned expense, an illness.” The Business Dictionary defines it as “Money which is set aside for an emergency situation, such as unexpected unemployment or injury, or a natural disaster which destroys one’s home and belongings.”
All these definitions bring out the basic features of the emergency fund. It is money set aside, but it also a source of ready cash. In short, it is very liquid (easily converted to cash). The purpose is to serve as a cover for financial surprises, unplanned expenses, unexpected conditions, and emergencies. These are the two basic features of emergency funds. It is money set aside in liquid assets in case of unexpected and unplanned circumstances. It is like self-funded insurance.
Do I need an emergency fund?
To ask the question is to answer it. Just like everyone needs one form of insurance policy or the other, everyone needs emergency funds. Though the size of emergency funds that Mr. A needs will be different from Mr. B, both should have an emergency fund.
[bctt tweet= ” Just like everyone needs one form of insurance policy or the other, everyone needs emergency funds”]
The reality of life is that, to a large extent, we don’t control the future. There are always potential circumstances that could occur beyond our ability to predict or expect. As a result, every human needs an emergency fund to avoid financial troubles in such emergencies.
Some of those situations include;
- Medical emergency
- Job loss
- Emergency (unbudgeted) expenses (unexpected travels, unexpected repairs, etc.)
- Poor performance from your business
- Natural disaster
Also, those in the gig economy (freelancers) may experience certain downturns. In those periods, an emergency fund may provide financial stability before a turnaround. The above also applies to small business owners.
Advantages of Emergency Funds
An emergency fund has very clear advantages.
One, it can help you avoid debt. Instead of turning to a credit card or a loan in the above-cited circumstances, an emergency fund can provide the necessary cover. Instead of paying interest on loans, your emergency fund will even earn interest. Your credit rating remains intact, and you can avoid all the emotional garbage related to loans.
[bctt tweet= ” Instead of paying interest on loans, your emergency fund will even earn interest. Your credit rating remains intact, and you can avoid all the emotional garbage related to loans. “]
Second, emergency funds help you to avoid a financial disaster and the life-altering responses that often accompany them. Like insurance, it gives you the cover and protection you need in the event of unforeseen circumstances. With a financial balance and stability, you can better manage most of these above circumstances.
[bctt tweet= ” emergency funds help you to avoid a financial disaster and the life-altering responses that often accompany them. Like insurance, it gives you the cover and protection you need in the event of unforeseen circumstances “]
Third, emergency funds help protect your savings and investments. Instead of redeeming your savings and investments (with withdrawal fees) to meet unexpected expenses, an emergency fund provides you with a painless cover. You can imagine how ugly it will be if you sold a stock at a loss just because there is an emergency that needs your attention. Perhaps you sold a stock on an upward trend and will have to buy back at a higher price with extra brokerage fees.
{bctt tweet= ” Instead of redeeming your savings and investments (with withdrawal fees) to meet unexpected expenses, an emergency fund provides you with a painless cover”]
The Size of your Emergency Funds
It is in this kind of situation that we have to recognize the “personal” in personal finance. The established wisdom is that you need an emergency fund that equals three to six months of your income or expenses.
Making your expenses the yardstick for the size of your emergency funds is a better decision compared to income. However, deciding the size of the emergency funds you need will depend on certain factors.
[bctt tweet = ” Making your expenses the yardstick for the size of your emergency funds is a better decision compared to income.”]
Job Security
One of the emergencies that necessitate an emergency fund is the loss of a job. To determine the size of your emergency funds, you need to assess the security of your job. Job security differs across industries and individual companies. If you are in an industry with great job security, you may need a smaller size of emergency fund. On the other hand, if you are in an industry with high level of job security, you probably need a larger size.
Job security also differs from company to company, even within the same industry. Assess the labor turnover rate of your company and decide accordingly.
Frictional Unemployment
Frictional unemployment is the type of unemployment that occurs as a result of people moving from one job to another. The period of waiting between a job loss and a new job also differs. It differs by industry, by individual skills level and type. Someone with a knowledge-based skill or a top-notch industry certification may spend less time in frictional unemployment. Someone without a knowledge-based skill or highly sought certification may need a bigger emergency fund.
Debt
The level of debt is another consideration. It is better to have a smaller emergency fund if you have lots of credit card debt and other consumer debt. In this circumstance, it is not wise to keep a lot of money in an emergency fund while debt continues to accumulate interest. In fact, in the case of enormous debt, a one-month emergency fund may be better. Rather, use the money to offset your debt and avoid all those recurring interests.
However, for someone with no debt, a larger emergency fund will be appropriate. If the only debt you have is a mortgage, you can also have a bigger emergency fund.
Marital status
A married person (if both partners are working) will generally require a smaller emergency fund compared to a single person. The income of the other partner can support a married person during emergencies. However, for a single person, such support is not available.
Dependent relatives
If you have people who are dependent on you, then you need a larger emergency fund. This owes to the fact that it is not only your emergency that must be covered. Your dependent relatives may also have unplanned and unexpected situations where you will need to intervene to avoid a financial crisis. The person with no dependent relatives won’t have to worry about this. Consequently, it will affect the size of your emergency fund.
Income source
Generally, a freelancer and a business person should have a bigger emergency fund (if possible) than the employed person (depending on the level of job security). This is because the former can face a downturn at any time in addition to unexpected expenses. But a salaried person with a stable income is not exposed to that same kind of downturn. Even if a salaried worker loses a job, he will find another, and that security will exist again for a long time (ceteris paribus). But freelancers and business persons may experience downturns that have no specific structure and requires better planning.
All these considerations are important in determining the size of your emergency fund.
Where should you put your emergency fund?
The important consideration here is liquidity and interest. Liquidity is primary, and interest is secondary. High interest yielding investments with low liquidity is bad for an emergency fund. On the contrary, a low interest yielding investment with high liquidity is a better option. But an investment with the same level of liquidity but with higher interest is the best option.
I have divided where to put your emergency fund into the first order and the second order.
First-order places to put your emergency funds include:
- Savings accounts: A high yield savings account will earn a considerable rate of interest and provide you with the liquidity required from an emergency fund. Interest rates vary from bank to bank. Some banks will not require any monthly fees or a minimum balance requirement. Those banks are better than the ones who will require them. Like every other savings and investment decisions, the key is shopping around. Savings accounts are also FDIC insured. You cannot lose your savings.
- Money Market Accounts: Money market accounts are like a savings account. They provide a better interest rate. You can open a money market account with a bank online or at a physical location. Money market accounts tend to have a higher minimum deposit requirement.
- Money Market Mutual Fund: Investing in money market mutual funds provide liquidity and considerable interest. Your emergency fund grows, and it is available when you need it.
Second-order places to put your emergency funds include:
- Certificate of Deposit: A CD is an instrument that allows you to put your money with a commercial bank for some time. The CD matures after that period when the funds become available for withdrawal. A CD offers a fixed rate of return for a time period. The longer the period, the higher the return but, the longer the period, the less liquid it becomes. Cashing out of a CD before maturity will lead to withdrawal penalties, which is what we seek to avoid with emergency funds. However, you can research certain banks that offer penalty-free CDs.
- Treasury Bills: Treasury bills are like CDs. They are instruments of credit used by the government to raise funds. You can purchase treasury bills for a particular period at a rate of interest determined by the discounted value and the maturity date. They sell at a discount on their par value]
The second-order investment destinations have lesser liquidity compared to the first order. They may come with higher interest rates. However, as said before, liquidity is more important here. It is wise to keep a higher percentage of emergency funds in the first order destinations and a little percentage in the second-order destinations.
Providing a Context
Your emergency fund must be part of your overall personal finance strategy. In terms of priority, it should not take precedence over paying off your credit card and consumer debt. However, it should take precedence over investing in stocks, bonds, and real estate.
[bctt tweet= ” Your emergency fund must be part of your overall personal finance strategy. In terms of priority, it should not take precedence over paying off your credit card and consumer debt. However, it should take precedence over investing in stocks, bonds, and real estate. “]
After paying your budgeted expenses, pay off your debt, load up your emergency funds (depending on the size you need), and then invest in stocks, bonds, and real estate.
When it comes to funding your 401(k) retirement account or emergency fund, it is a whole game plan on its own. This guide will help you through that decision.
Conclusion
None of us can control the future. As a result, we all need an emergency fund. The size of the emergency funds we need will differ. After we have decided how many months cover we need, there is a need to choose very liquid (primary) and high-interest yielding (secondary) destinations to put the fund. An emergency fund is an essential part of a fully orbed personal finance strategy. You should not neglect it.
[bctt tweet= ” An emergency fund is an essential part of a fully orbed personal finance strategy”]
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