“Anything that can go wrong, will go wrong” – Murphy’s Law. An emergency fund is very important and considered to be the first step of building wealth. The definition of an emergency fund is a fund or a collection of funds which can be used to cover unexpected expenses that are certain to occur to most people. As Murphy’s Law says: “Anything that can go wrong, will go wrong”.
Purpose of an emergency fund
There is little point trying to ignore the inevitable expenses as it could come as a big shock when they happen, leading to panic and impacting your finances.
Protect your investments
For the investor, an important use of an emergency or rainy day fund is to prevent the investor from using funds held within their investment portfolio to cover the cost for the emergency. If withdrawals are made from the portfolio at a premature stage, there is an immediate reduction of potential future growth and and income generation. Such opportunity costs are unacceptable, considering that they are totally avoidable by utilising careful planning in-order to set up an emergency fund. Use of specified funds for paying unexpected expenses will help to bolster your net worth. A video of how to track net worth is available here.
Sleep well at night
Other purposes of emergency funds are paying for events such as car troubles, loss of employment, injury or illness, parking fines, bank charges, dental costs, unexpected unavoidable travel costs and household repairs. Knowing that these expenses can be covered at any time will prevent stress when the situation arises.
Avoid financial troubles and debt
We have all seen it before – someone avoids paying a relatively small fee because they can not afford it. Before you know it the sum balloons due to added costs and then spirals out of control. Always having an emergency fund will help you to avoid spectres like using pay day loans, getting overdrawn or borrowing on high rate credit cards. Maintaining your financial health will help in other areas too as you will be able to maintain a healthy credit score.
How much to put in an emergency fund
The size of your emergency fund really depends on your personal circumstances and how much cash would make you feel comfortable. Some experts say that you need a fund to cover three months worth of expenses while some say up to a year of expenses. I think that to begin with, a relatively small emergency fund, for example $1,000 or £1,000 can be established.
A small fund is a realistic goal to achieve and will be able to cover most unexpected costs. Once this base is available, it can be built up over time to become more substantial. Rome wasn’t built in a day. You can even set up affordable monthly payments. Before you know it, a reasonable sum will have accumulated. In a good month you could put in a large amount and have less to worry about in future.
Personally I prefer to have a fund to cover roughly three months worth of expenses. It is also crucial to rebuild the fund once it has been used. From experience, I noticed that I typically need to tap into my fund two or three times a year.
Where to hold an emergency fund
The most crucial characteristic of an emergency fund is liquidity. By this I mean the ease with and speed in which the funds can be accessed for use. The fund has to be able to be accessed immediately and easily. Cash is King. Cash is the ideal vehicle for this, even though it is not expected to have good returns over time due to prevailing low interest rates.
Try to identify easy instant access accounts for cash savings. A separate designated account is best for this as you will know how much you have and track usage. Even though it is tempting, it is not recommended to use investment funds for an emergency fund as investments can drop in value very quickly. For example, in 2008 stocks lost as much as 35% in a year.
Start your fund now
Applying these simple steps will enable you to worry less about the future, avoid stress, protect your investments and more prepared to take on the challenges that life throws your way. Saving money is not easy but the alternatives are usually worse. The fund will remove more hurdles on the path to financial independence.