Introduction

The majority of financial advisers believe that an emergency fund has to have enough money in it to cover three to six months' worth of spending. You should be aware that accounts designated as emergency money are not held by banking institutions. Instead, it is the responsibility of the investor to open this kind of account and allocate funds for personal financial emergencies.

These funds should normally be kept in highly liquid assets such as money market instruments, savings accounts, overnight or liquid mutual funds, etc. These funds' main goals should be safety and liquidity rather than wealth growth.

An emergency fund: what is it?

Extra money set aside for personal financial difficulties is known as an emergency fund. Many people would need to use their emergency money to continue to survive in situations like losing their jobs, being sick, or experiencing a recession. Therefore, the fund's main objective is to cover emergency costs in the event of unanticipated events. This eliminates the need to use one's retirement money or take out high-interest loans.

Advantages of Emergency Funds

The following advantages come with creating an emergency fund:

1. Lowers stress levels

Emergencies like an abrupt job loss, auto problems, or unplanned home repairs do pose a threat to one's financial stability, which eventually leads to worry.

People are building up serious risks that could negatively impact their daily lives in the absence of any kind of buffer to counteract the possible occurrences. But by creating an emergency fund, people gain self-assurance and the capacity to deal with unforeseen circumstances without worrying about money.

2. Promotes saving habits

By creating an emergency fund, people are encouraged to save money and are less likely to give in to the desire to buy luxuries like video game systems and televisions.

3. Prevents bad debt

People wouldn't even have to think about utilizing bad debt, like high-interest credit cards, to cover their expenses if they had an emergency fund. Using this kind of debt can result in greater payments due to careless behavior because of extra interest, fees, and penalties.

Disadvantages of Emergency Funds

The following are some disadvantages of maintaining an emergency fund:

1. Reduced retirement funds

Contributions to an emergency fund limit the amount of money that can be used for other purposes, such as retirement savings or mortgage repayment. Therefore, emergency funds make it less likely that other financial objectives will be met.

2. The opportunity cost of making an investment

Money is worth more right now than it will be later. People are decreasing their prospects of earning a larger return by investing in the stock market and being exposed to compound interest by adding money to the emergency fund. As a result, emergency funds forfeit the chance to spend their cash to increase their value.

Calculating Emergency Funds

Finding your appropriate emergency fund amount is a simple calculation.

Make a note of your monthly earnings: Your present pay, secondary income, bonuses, investment income, pension (if you are retired), and other sporadic revenue are all included in your monthly income.

Calculate your monthly spending: Rent, electricity, home assistance wages, groceries, EMIs (car, house, personal, and educational loans, etc.), and other sporadic expenses are all part of your monthly expenses.

Calculate how much money is spent on leisure activities each month. These consist include eating out, shopping, watching movies, and other pastimes.

Analyze how much was spent on travel. It covers things like gas and public transportation.

Determine how much you spend each month on your dependents: This covers things like family support, medical expenses, and tuition for school or college.

List other monthly expenses, such as gift-giving costs, insurance premiums, holiday spending, and subscriptions (gym, OTT services, etc.).

Lastly, double your monthly spending by six by the sum of your monthly expenses, travel, recreational activities, dependents, and other monthly expenses. You are now prepared to establish the emergency fund.

Why is an Emergency Fund Necessary?

You can prevent taking on unforeseen debt or depleting assets you've set aside for other objectives, like retirement, by keeping an emergency fund. For instance, taking out a loan or withdrawing funds from your retirement accounts to pay for an unforeseen need can lead to a financial hole that is hard to escape. Having an emergency fund could be beneficial even if you earn a lot of money or have a sizable running balance in your bank account.

An Emergency Fund Example

Here is a fictitious illustration of how to put together an emergency fund. Assume a married couple spends $5,000 a month on costs. This covers the couple's food expenses, auto payments, mortgage, and other essential expenses. According to the three-month guideline, the couple must budget at least $15,000 to cover unforeseen expenses (or $30,000 for six months and $40,000 for eight months).

How can I create a Fund for Emergencies?

Creating or keeping an emergency fund might be difficult for many people. To begin, take these actions:

1. Consider opening a simple money market or savings account.

It should ideally be connected to your bank account. The money should be available within a day, but not immediately. You want this money to remain liquid and safe. Since stocks and bonds are susceptible to market risk, it is not advisable to invest in them.

2. Seek out an account that reimburses you.

An annual interest on your money is provided by certain high-yield savings accounts.

3. Begin modestly

It's not necessary to budget for all six months' worth of costs at once. Until you hit your goal, think about establishing automatic withdrawals from your paycheck.

4. Tap the account only in cases of genuine emergency.

A fender bender, losing your job, a busted pipe, or a high medical cost are a few examples of this.

5. If you take money out of the account, replenish it.

Rebuilding the account should be your top priority after surviving an emergency so that it will be available when you need it most.

Conclusion

Nowadays, the majority of people aim for financial independence earlier in life. Their goal is to have all of their financial needs met by the time they retire in their forties.

Building an emergency fund that covers all unforeseen costs shortly is the first step, even if this requires careful planning and intelligent spending. Even if this looks excessive in normal circumstances, it can be quite helpful in emergencies like the current lockdown.

This year is the ideal time to start your emergency fund-building adventure if you haven't already.

Have fun with your investments!