Uncertainty is the only certainty in life, a fact of life that promises to keep anyone working and earning today up at night. Despite our best efforts at putting aside a rainy-day fund, we’ve all had to be bailed out of an unexpected situation by a helpful friend or someone in our family at one point or another. Sometimes, even when we think we have enough money set by, it often happens that our money becomes inaccessible to us because they have been locked up in a time-bound investment or because we’ve lent it out to someone else, or because we’ve dipped into it ‘just for this once’. Unfortunately, it’s often at these same moments that we break our taillights, spill a drink over our phone or remember that we need to stock up on groceries for the long weekend. This is why it’s important to set up an emergency fund that is separate from your usual savings account or investment portfolio. A dedicated fund for unplanned expenses will also help insulate your other funds and long-term savings against the shocks of an unexpected situation. It will also ensure that these unexpected situations do not send you into debt.
Now that we know why an emergency fund is necessary, the next question is how much we need to hold in it. A general rule of thumb amongst financial advisors is that an emergency fund should cover one’s living expenses for three to six months in the absence of any other income. However, it’s important to remember that the actual amount you should hold in reserve should also depend on your context. Holding six months of living expenses in reserve makes little sense if you cannot provide for your basic necessities today. Another useful standard to consider is to set the most common kind of expense that pops up unexpectedly in your life and set it as a benchmark. This may be the amount necessary for an ER visit if you frequently suffer from food allergies or the cost of several months’ worth of medication if you suffer from a chronic condition, such as diabetes. The amount you ultimately do set aside should also reflect other considerations such as any dependants on your income and any insurance you have taken out against emergencies as well.
Leaving aside a significant amount of money may feel like a cause for anxiety in itself for someone making minimum wage for example. However, setting aside what you can to build up a fund over time can ease some of the mental strain of having to live from paycheck to paycheck. There are of course certain strategies you can employ to build up to the end goal of setting aside a substantial fund for emergencies.
Before anything else, it’s of course necessary that you create and maintain a savings habit for yourself. This becomes easier if you can put a set amount of money away consistently with every payday, but of course, not everyone has the privilege of enjoying a consistent income.
If your income is often subject to fluctuations or if your ability to save is limited, the easiest approach would be to start saving a portion of any tax refund you receive. Establishing the size of the fund you want to set up will help you work to save consistently, and seeing yourself slowly reaching your goal will also provide you with a sense of satisfaction that will encourage you further. Setting up this fund in an interest-earning account will help you reach your goal that much faster.
In fact, your emergency fund should ideally be set up in a basic savings account or in a money market account, albeit separate from your usual checking account. This keeps the money separate from daily expenses while still keeping it accessible. Above all, it should not be exposed to market risk. This account should be reassessed periodically to ensure that it reflects any changes in your situation, and to ensure that it is replenished appropriately if you suddenly find yourself dipping into it in an emergency. Setting up a basic account for your emergency fund will have the added benefit of allowing you to automate your savings process, which will increase the consistency at which you save. Setting up a recurring transfer system will prevent you from ever touching the money in the first place, which will protect it from being spent on things you will not necessarily miss. However, it’s also important to remember to check the balance of your regular account frequently to make sure that you aren’t going into debt with the bank due to the automation, which will incur the expense on your behalf even if you don’t have money in the account. A recurring reminder on your phone should help balance this out!
Another way of automating your savings is by directing your employer to pay into two separate accounts, where your paycheck is split between the two. This might not be possible with every employer of course, and will likely require a little research beforehand.
In the event that you see absolutely no space for savings in your income, the other option open to you is managing your cash flow to fit your needs. This ultimately boils down to timing what you spend in relation to what you earn in order to pinpoint those instances where you can cut a corner or two to put a little money aside. Getting the timing of the outflows in your money will depend on your ability to negotiate with service providers and vendors such as your landlord, the utility companies you subscribe to, and your credit card company. Spacing out these payments should help prevent you from running out of cash at the end of the month, exactly when all the other bills are due. It will also help you make full use of one-time opportunities to save such as seasonal credit card offers or a shopping coupon.
Even as you get into a regular saving habit and build an emergency fund, it’s important to remember that maintaining such a fund can have its own downsides, which is why you should always try to avoid oversaving for an emergency. Some investment advisors even believe that holding onto such a fund is ‘overly prudent’. Instead, they suggest that the money that goes into these funds should be directed towards improving your financial situation in other ways, such as paying off any short or long-term debts. Even if you don’t personally subscribe to this belief, it is still important to remember that your emergency fund is exposed to a significant inflationary risk, as an emergency fund tries to preserve its liquidity over its earning capacity. Depending on the economic situation in your country, you may well find that the purchasing power of your fund or the real value of your money is actually decreasing over time.
(Theruni Liyanage)