What is An Emergency Fund And Why Do You Need One?

The outcome of many life events are unpredictable!

Sometimes, unexpected events occur. What if the company you’re working for folds up all of a sudden?

Or if a storm damages a significant part of your home leaving you and your loved ones homeless for a while?

Or perhaps the government shuts down again because of the wall or another reason?

Because several things may happen when you least expect is one of the main reasons why you need an emergency fund.    

What Exactly Is An Emergency Fund?

An emergency fund refers to an account for funds that are reserved in case the owner runs into financial distress like the loss of a job, severe disease, illness or significant damage to a home.

The essence of an emergency fund is to enhance your financial security by establishing a safety net of funds that you can use in the event of unexpected expenses.

Also, emergency funds can reduce the need to obtain loans from high-interest debt options like unsecured loans or credit cards.

How Much Should An Emergency Fund Contain?

Ideally, you have the absolute freedom to decide how much you want in your emergency fund depending on the source of your income and how much you’re earning.

However, most emergency funds usually contain at least three months’ worth of income as recommended by many financial planners.

It is worth mentioning that financial institutions do not set up accounts known as emergency funds.

Rather, you as an individual, is expected to set up an account and label it as capital set aside for personal financial distress.  

For example, a couple who makes $150,000 annually after taxes, should reserve an instantly accessible minimum of $37,500 (three months) to $75,000 (six months) to cover up for sudden financial distress.

Most importantly, the fund must be highly liquid and left in savings or checking accounts.

Having such liquid funds makes it absolutely easier to quickly access cash to resolve unexpected household expenses and other unexpeced costs during an emergency.

The Relevance of Emergency Funds While Investing

Many financial advisers see investment strategies as structures that are similar to a pyramid.

A vibrant foundation is absolutely crucial to support the amount of risks an investor is exposed to as securities considering the various levels of volatility that may affect such a foundation in the long run.

Before considering any intermediate or long-term investment opportunities, you’re expected to have an emergency fund.

Most financial advisers strongly recommend that you have one.

This is considered the first key step in minimizing risks and establishing some levels of stability.

When you set aside three to six months’ worth of income in highly liquid market, like the money market, it can lead up to the buying of any mechanism that may hold risks to principal or is needed for lock-in periods when penalties are evaluated for early withdrawals.

Aside investing, there are several other reasons why you may need an emergency fund.

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How to set up an emergency fund

There are several different theories about how to start an emergency fund.

While the outcome is the same, to have some amount of money set aside for an emergency, the methods of creating the funds are quite different.

However, in the process of developing your own fund, here are the key things you should consider:

  • What financial risks are you exposed to? (Health care deductible, car, and mortgage etc.)
  • Who are your dependents and how many are they?
  • What are your monthly expenses?
  • Do you have a stable and secured income?
  • What amount of money do you need to be financially stable and comfortable?
  • Do you have other sources of income such as an investment or an asset?

Individual’s emergency funds vary in size because we all face different financial situations regardless of how similar they are.

However, your emergency fund should be able to cover your deductibles without any hiccups.

For instance, your emergency fund should be able to cover up for an emergency job loss and serves as a quick access to cash whenever you need one.

So how exactly can you save for an emergency fund?

How To Save For An Emergency Fund

There are several things you can do to set aside some amount of money for an emergency fund.

One of the key approach is to cut back some of the things that you no longer need.

For example, you can cut back on the number of times you eat out or spend a huge sum on an unnecessary item.  

The amount of money saved can end up in your emergency fund every week.

The emergency fund will continue to grow as you increase your cut out on irrelevant spending.

You can also reach out to a credit counseling agency and sign up for a Debt Management Program.  

With cut back on your debt, you’ll end up with more money on your emergency fund account.

Here are other key things you can do:

1. Review your expenses

You’ll have to go over all your personal expenses.

These include your monthly bills, mortgage or rent, credit card, food, car payment, insurance and other similar expenses.

You should multiply your entire living expenses by six, (that’s a six months-worth of savings).

You can set this amount as target for an emergency fund. You don’t have to set aside the money at once. Start small and watch it grow.

2. Prune your expenses as required

Once you figure out your monthly expenses, it will be easier to decipher where you can slash unnecessary costs.

One easy way to start is to throw all your loose change into a jar every night.

You can as well rent some movies rather than buying every theatre ticket.

3. Put away your credit cards

If you can put away your credit cards for a while, odds are you’ll end up slashing your debts significantly.

So you should do everything possible to live on a cash-only basis.

If you don’t have the cash to pay for an item, walk away from it.

Better still, if you’re an avid buyer, stay away from online retail sites and physical stores.  

4. Use an auto deduction method

Some companies can help you arrange an auto deduction method of sending some percentage of your money into your emergency fund on each pay day.

You can start with as low as 5% or even lower or higher, depending on your personal expenses and how much you’re earning.  

5. Have easy access to your emergency fund

One of the key essence of an emergency fund is to have the money readily available whenever you have to access it.

This means you should opt for a regular savings or a money-market account.

As soon as you have up to three or four months’ worth of savings, you should consider having some of your money in a Certificate of Deposit in order to yield more interests.

6. Don’t use up the fund before an emergency

It’s easy to be tempted to use up your emergency fund for a non-emergency situation because it is easily accessible.

This is one of the most common mistakes many people make whenever they set up an emergency fund. You shouldn’t fall for such temptation.

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Key Reasons You May Need An Emergency Fund   

If almost every financial bump on the road is slowing you down because of unexpected expenses, an emergency fund can help you get back on track easily.

Here are key reasons you should have an emergency fund:

You want to get out of debt 

An emergency fund can stop your debt from piling up.

For instance, it can easily cover up for unexpected expenses that aren’t in your immediate budget.

This include unexpected expenses such as car accidents, car repairs, medical bills, and natural disasters etc.

With an emergency fund, you wouldn’t have to bother about taking out new loans to clear off unexpected expenses.

Protection from job loss    

Job loss is one of the key reasons why many people decide to set up their own emergency funds.

In an unpredictable economy, job loss is one of the unexpected things many people have to deal with.

If for whatever reason you lost your job without the possibility of getting another one that can offer the same level of payment anytime soon, having an emergency fund can save you from a whole lot of trouble down the road.

Without an emergency fund, the loss of employment could mean being spread thin financially and hoping to get any new job before running into any major financial crisis.

However, with an emergency fund, you wouldn’t be compelled to accept any offer that comes your way, especially when you hate the type of job you’re being offered.

Having an emergency fund gives you the opportunity to live off your savings while you carefully seek for a suitable job that matches your expectations.

Even more, having an emergency fund gives you the confidence to negotiate the salary you’re worth and not to jump on just any job that comes your way because you’re running out of funds.

Major health expense

Just one visit to the emergency room could end up leaving you financially drained if you don’t have a health insurance.

Even with a coverage, if your ailment requires getting a surgery, you may end up spending a lot in order to cover your health care’s deductible and co-payments.

Sometimes, you may be compelled to pay for a major dental health care.

Nobody loves a tooth ache, especially when you don’t have liquid money to see dentist right away.

You wouldn’t want to be caught off-guard, especially on medical bills and taking out a new loan could leave a huge hole in your pocket.  

Emergency pet care

While taking good care of your pet may not put a financial strain on you, spending thousands of dollars for your pet’s surgery could spread your finances thin.

Even if you have an insurance for your pet, it may not be enough to cover all the expenses required for a sudden surgery.

But with an emergency fund, you can be rest assured that your lovely pet has a better chance of survival rather than watching it die slowly.

Car repairs

It’s easy to conclude that you can use your credit card for repairs whenever your car broke down. 

But the essence of having an emergency fund is to save you from incurring more debt, especially during an emergency.

If you don’t have a car insurance, an emergency fund can easily bail you out.

If using your credit card to pay for your car repair will pile up more debt on you, then you should consider setting up an emergency fund right away.

Home repairs

Chances are your home insurance can cover up your major expenses.

However, if you have a high deductible, do you have the cash to cover up for it?

Also, insurance hardly cover everything that can possibly go wrong. So you may end up spending a lot as a homeowner.  

Unanticipated tax bill

What happens when you suddenly realized that you’re owing Uncle Sam a huge sum?

When you’re faced with a bigger-than-expected tax bill, it could affect your budget significantly and leave you without enough money to spend – even for a few days or weeks before your next paycheck arrives.

With an emergency fund, you’ll have something to fall back on. You’ll be able to live conveniently until your next paycheck arrives.

Unexpected travel expenses

A sudden event in the family such as a wedding ceremony, a birthday party or even a family reunion could compel you to buy a last-minute plane ticket.

You wouldn’t want such expenses popping up on your credit card bill and increasing interests.

However, with an emergency fund, you’ll have enough cash to easily pay for your traveling expenses.  

Read more: Why your credit score is crashing and what you can do to improve it.

Benefits of Having An Emergency Fund

1. Protect your retirement savings

An emergency fund can actually save you from dipping your hands into your retirement savings by stopping you from spending some of the money you have saved for your future self.

According to a Prudential study, an average of 1.5% of total assets in 401(k)/IRA accounts are lost annually as a result of early withdrawals.

While this may seem like an insignificant percentage, the outcome is massive.

The outcome of that early withdrawal is a massive 25% loss in retirement and in wealth.

This indicates that if you decide to withdraw $10,000 from your retirement savings right away for car repair, you may end up with more than $166,000 missing in the future when you decide to retire.

This means that getting an emergency loan from your retirement savings is too risky and not worth the risk.

Regardless of how small the amount of money may seem at the moment, it could cost you some parts of your long-term retirement plans.

2. Less stress about bill payment

The Prudent study further disclosed that up to 30% of employees revealed that stress about their personal finances have distracted them from doing their job as they should.

However, with an emergency fund, you can stay focused on your job rather than bothering about paying bills.

Interestingly, if you’re not bothered about money all the time, you’ll have more time to focus on finding a way to make more money.

As such, when you save for an emergency fund, you’re investing in your personal career success and boosting your productivity.

3. avoid the stress of maxing out your credit card

Once you have a few months’ worth of emergency fund, you wouldn’t have to put your car insurance deductible or roof repair on your credit card.

This can save you from the trouble of maxing out your credit card or other available lines of credit and save you from considering a high-interest debt like a payday loan.

Up to 12 million Americans obtain payday loans every year which results in $9 billion in loan fees, according to a Prudent study.

Constant high-interest debt can severely hurt your finances if you’re unable to pay down the balance every month, it grows bigger with as time rolls by.

This will trigger a series of other money issues like late fees and several things that can hurt your credit score.

Worst still, being in debt can make you lose sleep, cause anxiety, and even lessen work performance.

As such, it is far better to stay away from high-interest debt by simply tapping into your emergency fund whenever you have to.

4. Avoid the 10% penalty tax

It is easy to assume that a robust retirement plan is a great option as an emergency acount during unpleasant times.

So you may want to ignore an emergency fund which is liquid, and absolutely easy to access (without any consequence or tax penalties).

Nonetheless, when you use your 401(k) or any other tax-advantaged retirement plan as an option for getting some quick money, they attract significant tax penalties.

For instance, if you decide to make early withdrawals from your retirement plans before you hit the age of 59 ½, the consequences is a 10% penalty tax.

This is similar to losing 10% of that loan from your retirement accounts, rather than leave it to yield better results over several years.

This is why it is better to have an instantly accessible source of emergency savings, especially in a cash savings account that is funded with after-tax money.

5. Invest in higher-yielding stocks

One of the most overlooked benefits of having an emergency fund is that it can boost your confidence to invest in stock as one of your retirement strategy.

Many investors, especially younger ones, are often too conservative in how they allocate their retirement investments.

They are often too conscious about losing money. As such, they invest a lot of their retirement savings into low-yielding cash or bonds.

But if you have a reliable emergency fund to take care of your short-term financial needs, it can give you a better risk tolerance to invest in higher-yielding stocks as a part of your retirement strategy.

6. Stop borrowing from family and friends

Every year, on the average, Americans borrow $184 billion from their loved ones such as family and friends.

This makes up an average loan amount of $3,293, according to a survey from Finder.com.

So high-interest payday loans aren’t the only type of risky debt you can be caught up in.

While borrowing from loved ones may seem like a quick fix, the real challenge is around the corner when you’re unable to repay as agreed.

When you throw money into the mix of love, family and friendship, it can cause hard feelings and trigger financial trouble to you as a borrower.

You shouldn’t complicate your most valued relaionships with your money issues.

Rather, you should set up an emergency fund of your own so you won’t go running to your loved ones, family, friends whenever you need some money for whatever reason.

Bottom line

Having some amount of money set aside as emergency fund means saving for the rainy days.

You should never put yourself in a position to be caught off guard financially, especially when you have loved ones who depend on you.

Rather, set up an emergency fund to take care of unforeseen expenses that could leave you in debt or force you to seek new lines of credits that might leave a dent in your credit score.

Williams Oleije

Williams Oleije

Williams Oleije is an Inbound Marketer, and a pop culture enthusiast. He's an avid researcher about how digital media is transforming marketing in several industries.

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