What is an Emergency Fund?
An emergency fund is spare cash that is used during personal financial distress. Events such as the loss of a job, an illness, or a recession are examples of when many individuals would need to use their emergency fund to continue to survive. Thus, the primary purpose of the fund is to meet emergency expenses during unforeseen circumstances. By doing so, it reduces the need to borrow debt at high interest rates or to utilize one’s retirement funds.
Emergency Funds Approximation
According to many financial advisors, an emergency fund should be able to cover up to approximately 3-6 months of total expenses. For example, Bob’s expenses add up to $2,000 per month for his mortgage payment, food bill, credit card bills, and car payment. For safety purposes, his emergency fund should be $6,000 to cover three months’ worth of expenses and $12,000 for six months.
Benefits of Emergency Funds
Building an emergency fund offers the following benefits:
1. Reduces stress levels
In light of an emergency, such as a sudden job loss, car troubles, or unexpected home repairs, such incidences indeed threaten one’s financial wellness, which ultimately induces stress.
Without any sort of cushion to combat the potential events, individuals are accumulating significant risks that can be detrimental to their day-to-day lives. However, by building an emergency fund, it gives individuals confidence and the ability to overcome such unexpected events without being financially concerned.
2. Encourages saving behavior
By building an emergency fund, it motivates individuals to save and reduce the temptation of spending their money on frivolous goods, such as luxuries ranging from televisions to videogame consoles.
3. Avoids bad debt
With an emergency fund, individuals would not need to even consider using bad debt – such as high-interest credit cards – to fund their needs. Due to irresponsible behavior, using this sort of debt can lead to higher payments caused by additional interest, fees, and overall higher penalties.
Drawbacks of Emergency Funds
The drawbacks of keeping an emergency fund include the following:
1. Lower retirement savings
By adding money to an emergency fund, it reduces the option of allocating any additional funds to other programs, such as retirement savings or paying down a mortgage. Thus, emergency funds reduce the likelihood of achieving other financial goals.
2. Opportunity cost of investing
The value of money is worth more now than it is in the future. By adding money to the emergency fund, individuals are lowering their chances of receiving a higher return by investing in the stock market and being exposed to compound interest. Thus, emergency funds forego the opportunity to use one’s money to generate more wealth.
Prioritizing Investments or Emergency Funds
It is important to build an emergency fund before venturing off to grow other sources of revenue streams, such as investing in stocks. Although building a portfolio indeed yields greater long-term returns, the stock market itself is volatile, and returns can respectively fluctuate based on economic events that lead to a downturn, such as a recession.
Therefore, if individuals wish to invest with a part of their emergency fund, they may be able to do so through the following:
- High-yield savings accounts
- Money market accounts
- Certificates of deposit (CDs)
Setting up an Emergency Fund
There are two fairly simple ways to begin building up an emergency fund:
Distribute a fixed percentage of one’s monthly salary and allocate it to the fund. In order to do so, one must first calculate an approximation of their three-month living expenses as a target. Then, the individual can divert a portion of their paycheck accordingly to how many months they would like to achieve their goal.
For example, if Jon needs to save $6,000 to achieve three months’ worth of emergency funds, it can be split into $500 payments across a span of one year. Once the target amount is reached, additional savings can then be allocated for other financial goals, such as investing in the stock market or paying down the additional principal on a mortgage.
Another way to build an emergency fund is to save up one’s tax refunds and transfer that money to a savings account, rather than spending it.
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