What is an Emergency Fund?
An emergency fund is a source of money that you refrain from spending and store away safely to use in a time of need. Since it is readily available for withdrawal, savings invested in the name of emergency fund act as a savior during the unforeseen circumstances.
The emergencies can be a sudden job loss, emergency medical issues, or big losses in the financial market.
- An emergency fund is a source of assets that you can easily withdraw whenever you face an unexpected financial issue.
- It would help if you had something between three to eight months worth of monthly expenses in your account.
- It’s possible to store your cash in a bank savings account or get a CD.
- You should only take from the fund if you absolutely need it to avoid being empty-handed at an unexpected crisis.
How Does It Work?
As per a study, barely 40 percent of Americans will manage to pay for a sudden $1,000 emergency using their savings, the rest of them will have to borrow funds in the face of a calamity. The burden of borrowing can be averted many times by investing the savings in an emergency fund. The fund works like an insurance policy, only cheaper because you don’t need to pay for the premiums.
Unlike other investments, an emergency fund is usually invested in a savings account with a low risk of market swings (except inflation). Unlike stocks or other volatile investments, your earnings may not be big with this fund, but the money is guaranteed to be there when you need it.
Liquidity is another essential aspect of this investment. The main goal is not necessarily to profit but to have a solution during a crisis. Because of this, assets such as bonds, for example, are a terrible pick. They take a long time to reach maturity, and the last thing you want is to have your emergency cash locked away.
The main aspect, however, is that this is the cash that you only spend when necessary. Before using any money from your savings, you should ask yourself three questions:
- Is this new issue unexpected?
- Is it necessary to spend money on this?
- Do you need to spend it now?
If the answer to all these questions is yes, then use the emergency fund.
Examples of Emergency Funds
Most financial institutions won’t give you the option to invest in something called an emergency fund. Instead, they have other names, such as savings accounts. These are some examples.
#1 – Savings Account
The most obvious example of an emergency fund is a savings account. Not only are they readily accessible, but you can also receive a yield over time.
Be sure to research well to find the savings account with the higher yield, as it will be more profitable for you in the long term. Also, don’t be afraid to change banks if you find a better option. The essential aspect of the fund is not to leave it untouched, but to avoid spending it.
#2 – Certificates of Deposit (CD)
If you’re looking for a higher return on investment, Certificate of Deposits are a pretty good option. They offer a fixed return if you keep your money in them for a determined period.
The only downside in this option is the liquidity. In many cases, you need to pay a fine or lose your yield if you take your money too soon. A good solution for this issue is to open multiple accounts with different maturity dates. So, if you do need to take the money, you won’t lose much.
This is a more advanced way to save money, and it does have less liquidity. Even if you’re willing to invest some of your money in CDs, you should at least keep a handy amount in a savings account and use multiple CDs.
How Much Money Should you have in Emergency Fund?
There is no one exact answer for how much money you need in an emergency fund because it really depends on several points:
- How wealthy are you?
- How much money do you get every month?
- How much is your monthly cost of living?
- What are your other investments?
In short, the emergency fund of a millionaire would contain more money than that of young college students. Likewise, an emergency fund for students will require budgetary calculations depending on their part-time employment, scholarship or sources of income.
Fortunately, there are a few tips that may help you. For instance, your fully stocked fund should have at least three to eight months of your monthly cost of living. For example, if your family spends $3,000 per month, you need at least around $9,000-$10,000 to be protected. The ceiling can be as high as $24,000 in this case.
Remember that you need to put away only an amount of money that you are comfortable with. There’s no point in getting into debt to get eight months of savings because you will be actually losing money due to high-interest rates on your debts.
How Do You Build an Emergency Fund?
- Building your emergency fund is as simple as saving money. First, you need to determine your monthly expenses.
- Then, use this number to determine how much money you need for three months. That’s your initial goal. Then, set a realistic amount of how much you can save every month. It’s alright if the amount is not so big, but it should ideally be consistent.
- If you get $3,000 per month, for example, setting aside 10% ($300) would help you to reach your goal in two years and a half without taking a big cut of your salary.
- The best way to achieve this consistency is by living by your budget every month (which is why it is essential to create a realistic budget).
- You can set up automatic ways to send the money to a savings account, too, which will make it easier for you never to forget deposits.
- Another great idea is to save money when you get tax refunds. You won’t get them more than once a year, and it’s tempting to use the extra cash to buy something, but they will help you to accumulate money quicker.
- When your fund is complete, you can adjust it as needed by lowering how much you invest every month. You don’t need to overfund it. There are other investments that can be much more profitable, but they have more risk involved.