Should I have an emergency fund? The short answer is – yes!
Every now and then we all face minor emergencies, such as car repair or veterinary costs. Sometimes we also face major emergencies, such as losing your job or divorce. Even though most of us are aware of such risks, very few people have an emergency fund.
A small problem can become a huge one when you least expect it! The emergency fund helps you manage these risks by creating a safety net of funds that you can use to cover the emergency expense if it occurs.
Below I have listed some reasons why you should have an emergency fund (the list is not exhaustive):
- Avoid accumulating more debt (especially high-interest debt)
- Peace of mind
- Help your family when they need
- Think long-term
- Avoid bad financial decisions
Nobody has ever complained about how they wish they never had an emergency fund.
How to start saving for an emergency fund?
If you’re just starting out, you probably feel that it is very difficult to set aside anything towards the emergency fund. However, you should start preparing for the minor emergencies and then keep building up for the major ones as soon as you can.
The first step is to analyse your bank statements to see how much you earn and how much you spend each month (I prefer using a card for all my purchases so I can track my expenses many years back). Ideally, you should look back 12 months to account for seasonality effects. A simple excel spreadsheet would be suitable to do the analysis. You should also use the analysis to identify past emergencies – this will help you establish the target fund size.
I think that saving any amount, even $10 a month is a good place to start. For most people, it might be the only available option. However, there is a problem with this approach. You can set up a modest emergency fund in a couple of years, but the likelihood is that you will get hit with several emergencies while you are building up the fund. This means, you might not have enough money to cover the emergency and you won’t feel stress-free with your modest savings. If you have an option to save more, then do it. If you don’t, start building the fund slowly, it is much better than having nothing set aside.
How do I “fund” my emergency fund?
When I had to find extra cash for an emergency fund, I tried to cut back on spending and earn more money. Here are some ways how you can find cash for your emergency fund:
✓ Sell useless stuff: This might be the first and easiest thing you can do. Think about the stuff that you haven’t used for more than a year. If it has some value and you haven’t used it for a year, then sell it. It will only take extra space and lose value over time (unless it is an item that might appreciate in value, which it usually isn’t).
✓ Cut back on spending: Chances are you probably can reduce your monthly spending. Some of the largest items people spend money on are housing, food, transport and entertainment. Think about relocating if it saves you money. I recently moved much closer to work, saving on parking costs and commute time. All this money can go into building up your emergency fund or towards other investments. Some other useful ideas: Cooking at home rather than eating out (needs planning to actually succeed), cutting entertainment expenses for a couple of months or anything else more suitable to your situation.
Rational saving gives you more satisfaction than irrational spending.
✓ Side hustle: You probably won’t be able to save quickly only by cutting back on coffee, sweets or entertainment. Optimising your expenses is a very useful exercise but the amount you can save this way has a limit. On the other hand, making extra money by side hustling has no limit! Think about skills that you have that other people would be willing to pay for. Everyone can do something to generate extra income.
How much should my emergency fund be?
There is no one universal number that fits everyone. First, I suggest preparing for the minor emergencies that you have identified in your bank statement analysis. For example, for the first 7 months of 2018 (see table below), I spent almost 1 months’ worth of my average monthly expenses on minor emergencies.
Emergency expenses from 1 Jan 2018 to 31 Jul 2018 (% of my average monthly expenses)
As a result, I should have a minimum of 2 months’ worth of expenses in my emergency fund. In case some car repairs or other emergencies occur, 3 months would be even better (remember, past is not always a good predictor of the future, so a slightly larger emergency fund might be very useful).
Then, keep building up your fund for the major emergencies to the amount you feel comfortable with. When doing so, think what you are scared of the most and how much money you need to set aside to reduce the fear. You should take into account the chances of losing your job, your current debt level, whether you have a mortgage to pay and whether your income is regular/irregular. If you are not highly confident about your income stability, then it would be good to save at least 6 to 12 months’ worth of your expenses to cover small and medium emergencies.
Best place to keep my emergency fund?
The simplest and best way is to put your money in a separate bank account that you are not using for your daily purchases. You need to keep your money separate, but easily accessible when an emergency happens.
You should not invest your emergency fund in bonds, stocks, ETFs, cryptocurrencies or anywhere else, even if it’s a low-risk asset. Any amount that you invest, even at very low-risk, has the potential to lose value. In case of a market downturn, people are more likely to have emergencies and your savings will lose value at the same time – hardly an ideal situation! Finally, keeping your emergency fund in cash is also not the best option since you can lose it, be easily tempted to spend it on daily needs or someone can steal it from you.
Your emergency fund is for reducing risk, not earning an investment return.
So, should I have an emergency fund?
Yes! Having an emergency fund is a must for everyone (unless you are super rich). Start the fund small if you don’t have other options and build it over time. You will be less likely to accumulate debt and your financial plans won’t be affected by a single unexpected event unless it’s huge. Once you get hit by the first emergency, you will know the value of having extra money set aside and easily available.