Financial emergencies can befall anyone in any form during their life term. Be it in the form of loss of job, sudden illness or death. Emergencies like this often cost heavily on the financial resources available to a person’s disposal and hence financial consultants and investment advisors always urge people to keep a contingency fund or emergency fund.
Let us learn about more about this crucial step of financial planning.
What Is an Emergency Fund?
An emergency fund is a readily available source of assets to help one navigate financial dilemmas such as the loss of a job, a debilitating illness, or a major repair to your home or car. The purpose of the fund is to improve financial security by creating a safety net of cash or other highly liquid assets that can be used to meet emergency expenses, as well as reduce the need to draw from high-interest debt options, such as credit cards or unsecured loans—or undermine your future security by tapping retirement funds.
What Advisers Recommend?
An emergency fund should contain enough money to cover between three to six months’ worth of expenses, according to most financial planners. Note that financial institutions do not carry accounts labeled as emergency funds. Rather, the onus falls on an individual to set up this type of account and earmark it as capital reserved for personal financial crises. An emergency fund is a financial safety net for future mishaps and/or unexpected expenses.
Financial planners recommend that emergency funds should typically have three to six months' worth of expenses in the form of highly liquid assets. Savers can use tax refunds and other windfalls to build up their fund.
Two Strategies to Set Up an Emergency Fund
Starting early is key to setting up an emergency fund, because it helps you build up a comfortable cushion against unexpected emergencies later in life. Getting a start on emergency funds is relatively easy. Here are two simple ways to begin saving for an emergency fund:
• Set aside a comfortable amount from your salary each month. Calculate your living expenses for at least three months and make that your target for an emergency fund. You can then divert a portion of your paycheck—perhaps by setting up an electronic withdrawal—to that account each month. Once the fund is built up to the level you need, invest extra savings for the long term or for other goals, such as the down payment on a mortgage. Once you've maxed out your retirement savings, that money could go into a investment account, with higher risks and rewards.
• When you get your tax refund, save it. The tendency for most of us is to consider a tax refund as “extra” cash, which consumers may be tempted to use for discretionary purchases. Instead of spending the tax refund, save it as a contribution toward your emergency fund.
The Don’ts for the Emergency Fund
You should only include the necessary activities for your daily lives in the Emergency Fund. You do not need to withdraw from your emergency fund for getting your hair and nails done or clothes shopping. The emergency fund is like a survival kit. It is strictly to be funded and used to keep a roof over your head, basic clothes on your back, and food on your table.
• Do not take out money from your emergency fund for the Non-Emergency activities after you build it.
• Do not borrow from your emergency fund because you want to go on vacation or buy a new car or want the latest television or iPhone. You should create a separate “fun account” for such expenses. If you want to take a vacation, then start a vacation fund. If your goal is to buy a brand-new car or even a television save for it and better yet, buy it when there are some great sales and deals. But do not ever use the emergency fund for non-emergencies.
• Do not consider Credit Card as Emergency Fund. Please do not consider your credit card as your emergency fund because it isn’t. Not only are you going to owe more money to cover the expenses, but you will pay interest on it which is not a good way to spend your money.
Everyone can build an effective emergency fund. Determine what your expenses are during a three to six months’ time period and do your best to make regular contributions to your designated account.
When to Spend Your Emergency Fund?
Spend your Emergency fund only when you have use it for regular survival. It must be able to support you for the basic necessities only and not for luxuries. When the time comes to use your emergency fund, get accustomed to compromising on many things which were more accessible previously. Be very selective when you plan to spend from your Emergency Funds.