Emergency funds, or “rainy day” funds, are the basics of good financial planning. However, according to a Bankrate survey, only 37% of people would be able to pay for unexpected expenses with savings. An emergency fund is synonym of stability and minimised risk, so you must establish it before considering investing your money in other ways.
Emergencies can happen any day – be it an unexpected car expense (hope it doesn’t happen but these could add up to several thousands), losing your job (and your main source of income to pay bills), or an unforeseen medical expense (you might have insurance but still have to cover deductibles and co-payments). Again, we hope these don’t happen, but they could any day!
An emergency fund is made up of 3 to 6 months of living expenses (we heavily suggest 6 months!). Simply add what you spend monthly on mortgage, utilities, car loans, insurance, groceries, and other essential expenses (even fun and entertainment) and multiply the total by 6. This will give you 6 months to recover from an unexpected expense.
Your emergency fund should be liquid (this is how quickly it can be converted to cash) and accessible, so it should be in the form of a checking or savings account (which are 100% cash) and not stocks or real estate (can take too long to sell). If an emergency comes, you need your money available to you right away.
The main purpose of your fund is not to gain interest or returns. Since returns are directly proportional to risk and you need low/no risk for your emergency fund, you will have very little returns. If you are more risk-tolerant and have a more stable financial situation, you could break down your fund into short-term and long-term. The short-term fund would be a savings account with 3 months of living expenses (it can be accessed immediately) and the long-term fund would be another 3 months of living expenses in the form of high-quality bonds, for example (they have low risk, higher returns than a savings account, and can be made cash in a few days).
You don’t have to build your emergency fund all at once, unless you have the money to spare. Determine how much you can contribute per month and see how long it will take you to complete it. Don’t forget to be consistent and make it a priority – you can even set up automated payments from your checking account to your emergency fund savings account. If you need to, cut on unnecessary expenses to be able to build your fund. If you’re in a lot of debt, build a smaller fund (say, $1,000), decrease your debt and when you’re debt-free, continue to pay to your emergency fund.
In summary, your emergency fund must be:
- Low/no risk
- A priority that you MUST get done