What is an Emergency Fund?
So you have paid off all of your debt and want to take the next step in your personal finance journey but you don’t know where to start? Do you have a fully functioning emergency fund set up? If not then that should be your number one priority!
But first what exactly is an emergency fund? An emergency fund or rainy day fund as it is sometimes referred to is simply a sum of money that has been put aside in case things go wrong – a financial emergency.
It certainly isn’t shiny and exciting like investing in the stock market or beginning a side hustle, but do not overlook the importance of having an emergency fund set up at all times. The consequences of not having one if things take an unexpected turn, can be catastrophic on your personal finances.
Your emergency fund should contain at a minimum, enough money to pay 3-6 months worth of expenses. Of course, everyones individual circumstances are slightly different. For some people 3-6 months worth of expenses is $20,000. Yet for others it can be $100,000. So, it is extremely important to work out exactly how much money should be in your fund based on your individual life circumstances and no one else’s.
You might be beginning to wonder how an emergency fund is any different to a simple savings account with some cash sitting in it. Well the principle of an emergency fund it that it is not to be touched for anything unless a true emergency.
To make you less likely to dip into your emergency fund, it is highly recommended to open up a seperate savings account, with a different bank account to your exisiting one. Of course this isn’t 100% necessary but often helps stop you from dipping into the money for reasons other than an emergency.
Hint: If you knew it was coming, it is not an emergency.
- Not an Emergency
- A house deposit
- A holiday
- Bills that you knew were coming
- You lost your job or primary income
- Large unexpected expenses
- That’s it!
Why You Need an Emergency Fund
Now that you know exactly what an emergency fund is and what is deemed an emergency it’s time to take a look at why having one set up should be at the top of your priority list.
Having a fully funded emergency fund has three major benefits, each as important as the other.
Peace of Mind: Without having a rainy day fund, you are gambling that nothing will go wrong in your life. Living like this can be extremely stressful, scary and overwhelming. The sad part is that this is exactly how so many people live. They earn just enough to pay their bills, feed themselves and put a roof over their head. Yet, they live with the burden of knowing that if they stumble across any financial road bumps, they are going to be put under severe financial pressure. It is not a nice way to live. Having a rainy day fund can allow you to live freely knowing that if life throws something unexpected at you, you can handle it!
Things Go Wrong: It is a reality that in life things don’t always go to plan. You may get a speeding fine, a leak in your roof, you may lose your job, someone may steal from you… The list is endless. Without an emergency fund, you risk being financially unable to cope if something major is to go wrong. Whilst also giving you peace of mind, having an emergency fund ensures that you are financially able to cope if something major was to go wrong.
Investments: If you have stumbled across this post, chances are you have some investments of your own or at the very least understand the basic nature of an investment. The two most common asset classes are stocks and real estate. They are both typically good long term investments (this is not investing advice) yet can fluctuate in the short term. If the market drops, most long term investors will sit tight and ride out the dip. If you don’t have an emergency fund set up and encounter a financial emergency you may be forced to sell your investments at a poor time, effectively locking in a loss that could have otherwise been avoided.
How Can I Build an Emergency Fund
So you know understand the basics of how an emergency fund works and why they are so important. But lets face it not everyone has spare money floating around so how are you meant to just gather 3-6 months work of expenses? I have put together a list of ways that can help you build your own emergency fund.
- You can temporarily or permanently pick up a side hustle to earn extra income to fund your emergency fund
- You can cut down on some expenses (even if only slight) and use the savings to fund your emergency fund
- You can automatically allocate a portion of your income to building up your emergency fund – it doesn’t have to be large amounts
- You can rummage through your house and sell some junk you don’t use to fund your emergency fund
It’s not flashy or exciting, but setting up your emergency fund is one of the most pivotal steps towards achieving financial freedom. In fact, not having one can undo years and years of good work in a heartbeat.
You should firstly get an idea of how large your fund should be based on your level of expenses. From there the sooner you can start building it the better. By using one or a combination of the three strategies listed above you should be able to get your emergency fund up and running in no time. If you would like to learn more about emergency funds, you can find some excellent resources on at Moneysmart.