I got a call from a school friend who lost his operations manager job. Without monthly income – he was worried about the mortgage and medical supplies.
He needed 3-4 months’ time to find another job.
A layoff situation can completely blow your monthly budget if you aren’t prepared. Either you need to borrow money from friends & family or from financial institutions.
Another way is to liquidate your investments. In that case, you lose the growth opportunity.
But there is an alternate route – you can create an emergency fund.
The emergency fund keeps you prepared beforehand to face a sudden unexpected event.
What is an Emergency Fund
Unexpected events keep on happening in everyone’s life.
They come in many forms –
- Unfortunate car accidents
- Major home and car repairs (outside of regular maintenance costs)
- Sudden illness and drop in income
- Unexpected job loss
- Unplanned moving expenses
You simply can’t guess.
Having some money set aside in an emergency fund beforehand keeps you going without much hardship. You are able to handle unexpected expenses like car repairs or pay for a mortgage while still, you are job hunting.
The money saved in an emergency fund will support your monthly expenses.
Why do I need an emergency fund
The purpose of an emergency fund is to provide you with enough money to cover unexpected costs and help pay bills & mortgage when you are out of the job.
Emergency funds create a financial buffer that can keep you afloat in a time of need.
It will keep you away from borrowing money at high interest or max out your credit cards if the situation becomes financially challenging.
Money identified as an emergency fund needs to be kept aside in a separate account so that it doesn’t mix with regular savings.
People use savings, a taxable accounts, a money market, or even a checking accounts for emergency funds.
A recent poll shows – 80% of people use savings accounts for creating an emergency fund.
What is a Savings Account
Banks and credit unions offer you a savings account when you ask them for creating an emergency fund.
Savings accounts are where you set aside money for a particular goal.
The goal can be short-term, such as saving – to cover the cost of a down payment on a house. It can also be towards purchasing a new car.
Long-term goals can be – saving for retirement or for your children’s college education.
Money is money for banks. It doesn’t bother them whether it is for an emergency or for savings
The onus is on you to identify one of your accounts as an emergency fund.
Emergency Funds vs. Savings Accounts: Key Differences
|Emergency Fund||Savings Account|
|Used to mitigate urgent situations and crises||Intended for a specific goal|
|The interest varies based on account type but is generally low yielding||Saving accounts have a slightly better interest than the money market and most checking accounts|
Emergency Fund vs. Savings: How Should You Use Them?
If your life goals are fixed like funding for your college studies, a one-week vacation in Thailand, or buying a house then you should use a savings account.
Use emergency funds for a financial emergency caused due to an unseen event.
For example – a sudden breakdown of your thermostat, hospitalization due to an accident or a layoff.
Don’t dip into an emergency fund just for meeting the shortfall in your monthly budget.
How Much Should You Save in an Emergency Fund
The exact amount varies from person to person. It depends on your income, your current lifestyle, monthly costs, and dependents.
The standard recommendation is to set aside between three and six months’ worth of your current monthly expenses. So that you don’t cut down on your present lifestyle or be forced to liquidate your investments.
How to Start an Emergency Fund
#1. Set Emergency Fund Amount
Choosing a goal figure is the first step. Your emergency fund goal can be $1,000 or $5,000 if you are a student.
For single working professionals or for a family of 3-4 members $10,000 or even a higher amount can be taken based on your current lifestyle.
You can start by aiming to save $500 or $1,000 for an emergency if that sounds too much.
The goal amount figure is entirely on you.
You can increase the amount when you get a bonus.
Once you decide, the next thing is to figure out how much to save each month for an emergency fund.
If you aim to create $5,000 as an emergency fund in a year. Then $10,000 / 12 = $417 is the amount that you need to contribute to the emergency fund each month.
If you are unsure about how much you can comfortably afford to save each month then you need to have a budget.
Track your income and spending for at least two months. Examine your expenses and spending closely to see if you have funds available to set aside.
Next, you need to open an account at the bank.
#2. Picking up an Account
Account options for emergency funds include –
- Checking account
- Savings account
- Money market account
Pick an account that is instantly accessible, offers high liquidity, and charges 0 penalties. If you are getting some interest then that will be good enough for an emergency fund.
Liquidity refers to – the ease of withdrawing your money when needed.
Checking and savings accounts are very liquid, while investment accounts like – mutual funds, CDs & bonds are less liquid. They take 2-3 days to make money available.
Emergency funds are best placed in a high-yielding savings account, that can be accessed easily without taxes or penalties.
The concern with placing emergency savings in mutual funds and stocks is that – they may lose value if the market goes down.
Other emergency fund account options –
#1. Credit or Prepaid Cards
Using a credit card can be costly. You need to pay 15% or higher APR. Drawing a higher amount can hurt your credit scores.
Prepaid cards are not connected with a bank or credit union, but you can only spend the amount that’s on your card.
Keeping cash on hand for emergencies is another option. But the problem is that cash – can be easily lost, stolen or destroyed.
Emergency becomes a crisis when you don’t have funds for sudden medical supplies, hospitalization expenses, or car repairs.
Having ready money to cover an unforeseen major expense takes the additional strain on finances out of an already stressful situation.
An emergency fund gives financial security by providing a safety net for times when the unexpected happens.