Emergency fund is a key concept that is instrumental in establishing financial well being on one hand and avoiding financial fragility on the other hand. Emergency fund builds financial capability and this capability is critical in building financial wealth. Financial capability, a very broad concept, refers to the ability of people to be in control of and properly manage their finances. Financial capability encapsulates knowledge, skill and understanding of one’s own financial and personal circumstances so strongly as to take action. Financially capable people have been found to plan in advance. They tend to find information, seek advice so as to use that information for greater participation in the financial services market. Financial capability leads to financial planning, which helps individuals to fill the distance between financial freedom and financial stress.
This generally induces people to prioritise investments, save funds and avoid inappropriate investments that don’t match the risk profiles or financial goals.
The concepts of Financial capability, financial planning and financial well being go hand in hand. Financial well being enables people to control everyday finances, absorb financial shocks, track and meet financial goals and have financial freedom. Financial capability enables people to be in control of their financial health and manage their finances to achieve financial well being.
On the flip side of financial capability is financial fragility. Financial fragility is an indicator of how weak the assets of an individual are to handle the emergency. Financial emergencies vary from person to person. An emergent situation for one person might be loss of job whereas for someone else it might be unexpected home repairs, unplanned medical expenses.
In order to provide for such financial emergencies, individuals should maintain ‘emergency funds’. An emergency fund is a “cash reserve that’s specifically set aside for unplanned expenses or financial emergencies”
An emergency fund helps a person to stay on strong financial footing when he is facing unexpected costs, and provides an essential way to protect oneself.
And emergency fund is the first step to start saving, first step to financial freedom, first step to provide financial cushion, first step to stop worrying about financial disturbances, first step to stay liquid, first step to build financial wellbeing, and first step to understand personal finance.
Johnson & Widows (1985) classified three measures of emergency funds based on their degree of liquidity:
- Monetary emergency funds: assets held in saving, checking and money market accounts.
- Intermediate emergency funds: Monetary assets plus deposits and savings certificates.
- Comprehensive emergency funds: Intermediate assets plus the value of stocks and bonds.
Monetary assets are said to be liquid assets, which can be converted in cahs or cash equivalent without any loss of item.
Having an emergency fund is like having a shock absorber for the bumps of life. To start with, you can ask yourself the following two questions:
- As of today, how much money have you saved for emergency expenses?
- Assume that you were facing an emergency expense of around $2,000 that could not be avoided, and you are required to make this payment within next 15 days. How early can you get these funds?
Emergency expenses can arise due to any reason like loss of job, car breakdown, repairs at your home, sudden plumbing requirements etc. financial emergencies can vary from person to person.
It is important to have an emergency fund as the lack of this financial cushion can be severe. It has been generally observed that households that have low liquid assets or do not maintain enough emergency funds could suffer financial distress if they experience an income shock. They are generally one financial shock away from the financial distress. One financial shock has the capacity to send financially fragile people to rely on debt, credit cards, and thus, making an emergency more costly with grave long term consequences.
What should be the amount of the emergency fund?
Emergency fund should be large enough to make you survive for a comfortable tough time that can last over the next few months. The quantum of emergency fund depends on the situation. Ideally, it should be something around the sum of monthly earnings for 9-12 months.
However, normally having a sum of 3-5 times of your monthly income is considered enough for an emergency fund.
However, the answer to this question is debatable. For preparing an emergency fund, we can take help from the 50-30-20 rule. This rule recommends putting 50% of your money towards needs, 30% towards wants, and 20% toward savings.
Following are few questions that should be considered to find answer to understand how to maintain an emergency fund:
- What is the amount of the emergency fund that you are planning to maintain?
- How much should you save for each emergency fund?
- In what time period would you like to build the emergency fund?
- How much can you save monthly in order to build this emergency fund?
How should I build an emergency fund?
You can build an emergency fund by setting aside a fixed amount at regular intervals in a saving account. Discipline in putting aside a fixed amount is must for maintaining an emergency fund. An easy way to accumulate an emergency fund is to make contributions for the emergency fund more automatic. This way you can make your savings in the emergency fund grow without any extra steps in the process. While putting funds in an emergency fund, we should put them in more liquid assets so that you can earn money and convert the assets into cash quickly.
You can follow the following steps to build an emergency fund:
- Set a goal: Setting a goal to build an emergency fund will help you stay motivated, help you to move towards your goal by keeping some fixed amount aside.
- Follow the target with discipline: Create a system to build an emergency fund by making consistent contributions with specific amounts with discipline.
- Monitor your progress: You should regularly check your savings, check for automatic notifications of your account balances, and monitor the amount in your emergency fund
- Celebrate your success: You should celebrate each milestone you achieve in setting aside your emergency fund.
Why do I need to build any emergency fund?
One simple reason to build an emergency fund is to avoid making a costly urgent situation more costly. Putting it in different words, we can say that this fund can provide a financial cushion against the financial shock. A financial emergency can turn out to be a strong push for an individual to make use of unhealthy credit, high cost personal loans, heavy debt or a flush of safe deposits, wash away your assets etc. This can have a lasting impact on the financial freedom of a person.
Emergency fund ensures that a person can resort to financial well being, take control of its day to day expenses and get back to its normal day to day life.