Expecting the unexpected is an inescapable part of life, with plenty of unforeseen circumstances both personally and professionally. Expenses can emerge out of the blue, making it absolutely essential to have emergency funds available to cover unanticipated costs. Setting aside money for an emergency fund is therefore a crucial component of financial health.
Read on for an explanation of an emergency fund, how to build one, and what it should (and should not) be used for.
What is an Emergency Fund?
An emergency fund is a dedicated amount of money that is left untouched for future, unplanned liabilities. Many financial experts recommend having enough put aside to cover up to three months of living expenses.
Accessing your emergency reserves could be necessary due to unexpected lay-offs and unemployment, a serious health issue that strikes you or a loved one, or perhaps a once-in-a-century pandemic that causes the global economy to enter into a state of hibernation. Simply put, any surprising twist that comes along and disrupts your life.
What distinguishes an emergency fund from a regular savings or investment account is the emphasis of having immediate access to these monies if the need arises. Therefore, these funds should be placed in highly liquid accounts, even at the expense of forgoing potential earnings elsewhere.
High-yield savings accounts are well-suited for housing these funds, though Certificates of Deposit can also work as long as the penalties for an early withdrawal are not exorbitant. In fact, there is some merit in placing these funds in accounts that require some bureaucratic action, as it will help ensure that the monies remain untouched unless they are truly needed.
Emergency funds should not be thought of as a store of money to be used for life’s pleasures. It would be a mistake to use these monies to take a vacation or upgrade your car. Those are legitimate savings goals, which you can and should work towards if they align with your desires. However, these are planned expenses. You want to make sure you have money put aside for the ones that you cannot anticipate.
How to Build an Emergency Fund
While the ability to save the equivalent of three months of expenses may feel out of reach for many, that is no reason not to begin building an emergency fund. Savings is the act of growing the gap between your earned income and your expenditures, a simple principle that everyone can follow.
Start by crafting a budget to help you understand where you can cut down on expenses and save money. Not happy with the monthly income you have at your disposal? Think about other ways that you can bring in additional income, such as through a side hustle or other forms of passive income.
Creating processes is a wonderful way to make sure that you are regularly adding to your savings. For instance, many banks will allow you to automatically transfer monies on a monthly basis from your checking account into a savings account. If your work offers direct deposits, you can also ask to have a portion of your monthly paycheck deposited into your savings account, removing the temptation to spend it on non-essentials.
Building an emergency fund requires flexing your savings muscle. Even if you currently lack much of a cushion to save, almost everyone can put aside a small percentage of dedicated funds with every paycheck. This will begin to accumulate, and the discipline of saving money on a regular basis will allow you to continue growing your wealth if your income increases.
How Does an Emergency Fund Protect Your Financial Future?
Having an emergency fund is more than just about creating peace of mind in case something goes wrong. It is a type of insurance fund against finding yourself in a deep hole, one that could have long-term implications for your financial health.
For example, let us assume that you have a medical emergency that your insurance only partly covers, leaving you with out of pocket costs that you do not have the funds to cover. If you place this bill on your credit card, you will immediately find yourself having to pay off debts at fairly high interest rates. This will not only increase your overall obligations, but it will also make it more difficult to pursue other financial goals such as saving for a down payment on a house or building your retirement account.
For those with a retirement account, raiding this store of funds to pay for an emergency can be tempting. It is also ill-advised, unless there is truly no other option. For starters, 401(k) accounts and IRAs are explicitly designed to save for retirement. Early withdrawals are generally subject to both taxes and penalties, unless you qualify for a hardship distribution.
Beyond the penalties, however, is the simple fact that monies spent will no longer be earning interest. While this is a fairly obvious point, it bears repeating, as the beauty of compound interest requires time to work its magic. The longer you can keep your money invested, the better off you will be when retirement rolls around.
Creating an emergency fund will therefore help you not only protect your current finances, but your future ones as well.
Conclusion: Be Prepared
“Prepare for the worst, hope for the best” is a wise axiom to live by. In an ideal world, your emergency fund will remain unneeded and untouched throughout your life, with all your major expenses planned for and budgeted accordingly.
There are, however, no guarantees.
Understanding the contours of an emergency fund–and what it should be used for–will prepare you for the unexpected.
Creating an emergency fund will allow you to navigate the potholes on the road of life, without landing in undue financial hardship and undermining your ability to reach your future goals.
Learn money management, and use data-driven stock insights with TipRanks.
