Do You Have an Emergency Fund?
Personal finance best practices say that before you even think about investing, there are two things you need to do. First: pay off any high-interest debt (i.e. credit card debt – this doesn’t include mortgages and bank loans). Second: save for a rainy day.
The COVID-19 pandemic has shown us that unexpected challenges can, in fact, happen when we least expect them. So let’s focus on the second part, building and managing an emergency fund.
What is an emergency fund?
An emergency fund is money that you set aside for large, unexpected future expenses. These expenses can arise from unemployment, unforeseen medical expenses, or the need for costly car or home appliance repairs. Basically, an emergency fund acts as your financial safety net so you don’t have to rely on high-interest loans to keep yourself afloat.
Before we get into calculating how much you need for your emergency fund, how to save for it, and where to keep it, there’s one thing you need to remember: This money is meant to be used; it’s not off-limits. You’re giving yourself a gift to face whatever life throws at you. So don’t feel bad when you inevitably have to use it, or a portion of it.
- You should keep about 6 months’ worth of expenses in an emergency fund – this is your safety net for any unexpected situations (such as illness or unemployment) that may come up.
- To build up your emergency fund, you should calculate your monthly spending, set a target timeframe, and consider lifestyle changes that would allow you to set aside more money each month.
- You should keep your emergency fund in a low-risk, liquid account. Ideally, it should also earn you interest so your funds don’t lose too much of their value to inflation.
How much money should you have in your emergency fund?
Your emergency fund should cover at least 6 months’ worth of expenses. To determine this amount, add up how much you spend in a single month on your needs(e.g. food), and the contributions you owe each month (e.g. monthly savings or a mortgage).
Even if you were to lose your entire monthly income, your savings goals shouldn’t be compromised – they’re there to make sure you reach your long-term life goals! Don’t let an emergency get in the way of that.
What one month's expenses includes:
🟢 Rent, utilities, phone bills, gym membership, streaming subscriptions, and other monthly bills
🟢 Food, regular medicine bills, petrol and transportation costs
🟢 Insurance, loan or mortgage payments
🟢 Monthly savings / investing and employee pension contributions
🟢 Giving money to your parents
What one month's expenses doesn't include:
🔴 That designer handbag or luxury watch you've been saving for
Now you know the amount of your monthly expenses. Multiply that by 6 months. That’s your emergency fund target amount.
You can also calculate how much to set aside for your emergency fund in our app’s habit centre.
Here’s how to build your emergency fund
The next question you need to ask yourself is: “Do I have this much in a cash or savings account?” If the answer is “yes”, can you afford not to touch it unless you have a real emergency? Yes? Skip to the next section. No? You need to make a savings plan to get there.
To save up the difference, a structured monthly plan is the easiest way to keep yourself accountable and on track.
Calculate your monthly spending to know how much you can put aside
Look at your monthly expenditures to know how much you can afford to put aside each month. From there, calculate how long it will take you to build your emergency fund with your monthly savings amount:
- Let’s say you need $30,000 USD for an emergency fund.
- You already have $10,000 USD in cash.
- That means you need to top up $20,000 USD.
Then, if you can save $500 USD per month, it will take you $20,000 / $500 = 40 months to build your emergency fund.
That’s a long time!
To build the emergency fund faster, you’ll need to save more each month. That means you need to adjust your budget and top up your fund a little more each month. Can you skip that extra kopi (and definitely that designer handbag)?
Set a target timeframe to build your emergency fund
If you’re committed to building an emergency fund in a certain period of time, you can also calculate how much you need to save each month like this:
So, again, if you need $30,000 USD for your emergency fund, and you already have $10,000 USD in cash, that means you need to top up $20,000 USD. If you need to save $20,000 USD in 12 months, that means you would need to save $20,000 USD / 12 months = $1,667 USD each month.
Consider making lifestyle changes to reach your target faster
If you can’t put aside larger amounts each month due to income and expense restrictions, consider whether you can make broader lifestyle changes. Could you be paying less for rent elsewhere or using public transport more, so that you can put more money towards your future? These lifestyle adjustments will allow you to build your emergency fund faster and be prepared for whatever life throws your way.
And, that extra savings capacity will pay off beyond building your emergency fund: once you have your emergency fund, you can start putting that monthly savings amount towards other goals. This strategy could make the difference between retiring 5 years earlier or buying a 3-bedroom home instead of a 2-bedroom home.
Where should you keep your emergency fund?
First and foremost, you need liquidity in an emergency fund. But that doesn’t mean you should put it under your pillowcase. At the same time, you don’t want to expose your fund to unnecessary volatility that could risk your cash just when you might need it.
Keep a few months’ worth of your emergency fund in a low-risk, liquid, interest-earning portfolio
We have a cash management portfolio, StashAway Simple™, that doesn’t take unnecessary risks with your cash. It has a projected 4.5% p.a. return on any amount (seriously, any balance has that projected return), with none of the hassle of investment requirements, credit cards, tiered earning structures, and whatever else the banks have come up with to make it painful to manage your cash. You can withdraw any amount of your funds at any time without penalties.
Consider keeping the rest of your emergency fund in a low-risk investment portfolio
If you’re looking for a slightly higher projected return on your cash, you could keep the remainder of your emergency fund in one of our lower-risk General Investing portfolios. Our lowest-risk investment portfolio has earned an annualised return of 2.3% and cumulative return of 11.2% in USD terms¹ since its inception in 2017.
Can you use insurance as your emergency fund?
Insurance policies can be great, but they’re a hedge, not an emergency fund. You should have an insurance policy that covers some of these high-ticket emergencies, but you shouldn’t view insurance as a cash equivalent. Because insurance claims can take time to process, you’ll still need liquidity for urgent expenses.
When should you use your emergency fund?
In a nutshell, you should only dip into your emergency fund for unexpected, urgent, and necessary expenses.
- Losing a job
- Refrigerator breaking down
- Unforeseen medical expenses
Emergencies are not:
- Last-minute vacation plans
- Planned medical and/or cosmetic procedures
- Down-payments for a house or car
I’ve used my emergency fund! What next?
If you used your emergency fund for a true emergency, then congratulate yourself for taking care of yourself and your loved ones responsibly! Next, temporarily put your other savings and investment plans on hold so you can build up your emergency fund again. If you have to buy that house 6 months later, so be it: the well-being of you and your loved ones in the short term comes first.
Do you have an emergency fund yet?
Unlike other savings plans that have longer time horizons, you should build your emergency fund as soon as possible, because you never know when you’ll need unexpected cash. It’s important that you build your emergency fund before investing in any of your other financial objectives. Although saving for the down payment of your first home may sound much more exciting than building an emergency fund, it’s best to protect yourself and your loved ones with a safety net as soon as possible.
¹ Returns of our General Investing portfolio with an SRI of 6.5%, as of March 2022.
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