If there is one thing that Covid-19 lockdowns, job losses, and the general uncertainty of 2020 have taught us, is the need for an emergency fund. Everyone agrees that having an emergency fund is good, however, only a few actually go ahead and build one.
What is an emergency fund?
According to Nerd Wallet, an emergency fund is described as a bank account with money set aside to pay for large, unexpected expenses, such as unforeseen medical expenses, home-appliance repair or replacement, major car fixes or unemployment.
Investopedia also defines the term emergency fund as the money kept aside by people to use in times of financial distress. The purpose of an emergency fund is to improve financial security by creating a safety net that can be used to meet emergency expenses, such as an illness or major home repairs.
Now that we have a full understanding of what the term means, let’s find out why one needs an emergency fund.
Why you need an emergency fund?
The main reason you should have an emergency fund is not to fall into destitution in the event you lose your source of income. Unfortunately, the reality is that your job can go away any minute, and you may not see it coming. Best prepare for it now when you still can.
Loss of a job is not the only emergency to look out for, unexpected car repairs, medical bills, unplanned upcountry travels etc. There is no shortage of spontaneous needs that have to be met. And without an emergency fund, you will most likely fall into debt.
Having an emergency fund will give you peace of mind. Life is unpredictable, and you’ve got to prepare for all the nasty curve balls it throws at you. Having a safety net is not a luxury you plan to get later when you are wealthier; it’s essential that you should strive to have now.
The general consensus among financial advisors is to save between three and six months’ worth of living expenses as an emergency fund.
How to build one
Make a monthly budget and live by it, and religiously save as much as you can. Saving at least 20 per cent of your income every month before you spend any of it is just enough to get you started. And top it up with any extra cash you run into.
There is a temptation to splurge when we get unplanned extra money. It may take you a while, but eventually, your back up fund will be enough to cover a few months of living expenses once well managed.
How much money should you have in your emergency fund?
There is no perfect amount for an emergency fund, and it will generally depend on your financial circumstances. But the first step is identifying all your monthly expenses; rent, food, transport, utilities, subscriptions etc. come up with a number and start saving towards it.
The rule of thumb is three to six months of living expenses. At the very least, three months is nonnegotiable. After saving three months of living expenses, is that enough? Am I now financially secure? Well, to answer that, you’ll have to ask yourself a few more questions.
1. Is my income regular and consistent? If it is, you are good. If it’s not, then you need to save another 3 months of living expenses to get you on the right track.
2. Do I have more than one source of income? If you do, you are good, if not, then you need to save another 3 months of living expenses.
3. Do I have dependents that I look after using my income? If you do, then save another 3 months of living expenses, if not, you are good.
So, while some people need only three months of living expenses in their emergency fund, others need a year’s worth. The sad tragedy of personal finance is that those who need an emergency fund most are those without it.
So, what do you think? Are emergency funds worth your time? Share with us your opinions, we would love to hear from you.
Interesting read: Are Women Better Than Men at Investing?
Author: Helene Nikita
Helene Nikita is a financial advisor, auditor, semi-retired financial analyst, free-market capitalist who loves sharing her financial knowledge and tips to anyone that wishes to improve their lives.