What is an emergency fund?
An emergency fund is money saved to meet unexpected expenses, such as future medical bills or unforeseen home and car repairs, or to cover a period of unemployment.
Having an emergency fund can help provide a sense of financial security and stability, especially during economic uncertainty.
What should be in your emergency fund?
An emergency fund should comprise mostly cash or other highly-liquid assets that you can access quickly in an emergency. This means you should not invest your emergency fund in assets that can take a long time to sell, such as property or high volatility shares, as the fluctuations in share prices may lead to you having to sell at a loss to access your money.
Think of an emergency fund almost like insurance. You set aside a portion of your monthly salary as a premium, and the fund pays out if you encounter any financial hardship. An emergency fund can enable you to rest easy, knowing that you already have the money available to deal with any unexpected curveball.
The ideal size of an emergency fund can vary. Financial advisors recommend enough to cover three to six months’ worth of living expenses. However, the economic uncertainty caused by the COVID-19 pandemic has encouraged more conservative recommendations of up to 12 months’ worth. Ultimately, you should tailor the size of your emergency fund to your unique financial circumstances.
Why is it important to have an emergency fund?
Almost all of us will face periods of financial hardship in our lives. Whether it’s due to the loss of a job, an unforeseen injury or illness, or damage to our home or car, financial stresses can come along and seriously upend our lives. An emergency fund can help relieve some of these financial burdens.
Knowing that you have money already set aside to meet these challenges can give you great peace of mind. Having a decent emergency fund also means you won’t have to rely on personal loans or credit cards to cover unanticipated expenses.
These sources of short-term funding can charge high interest rates, and the last thing you want to worry about in a crisis is racking up extra debt.
How can an emergency fund help psychologically during volatility?
If you have a high proportion of wealth invested in the share market, you might be sweating during times of heightened volatility. This is to be expected. When the size of your wealth is tied to the vagaries of the share market, it’s only natural to feel nervous when prices yo-yo daily. If the market goes south, you might worry about how you would cope if a significant expense arose and you had to sell some of your shares quickly – potentially at a loss.
However, if you already have a financial safety net, you don’t need to worry so much about short-term volatility in the share market. You can relax knowing that, even if money gets tight, you won’t be forced to sell your shares at a time when the market might be down.
This also illustrates why you shouldn’t invest your emergency fund in risky assets like high volatility shares. You should always think of your share portfolio as a long-term investment – it will grow over time with patience and discipline.
But, because the value of your portfolio can vary quite a lot from day to day, it’s not always wise to think that you can use it to cover any surprise short-term expenses. Almost by nature, these expenses always seem to pop up at precisely the worst possible moments! Setting up an emergency fund – separate from your share portfolio – is the best way to ensure you can cover these costs.
So, having some cash set aside in an emergency fund reduces your reliance on the share market and means you won’t feel quite as anxious during a market correction.
How much should your emergency fund be worth?
The appropriate size for your emergency fund depends on your circumstances. Ask five financial advisors, and they’ll probably give you five different answers.
Your emergency fund should be tailored to your circumstances and unique financial needs. For example, a single parent with a mortgage might need a larger emergency fund than a university student who still lives at home.
Or you may naturally be more risk-averse and require a larger emergency fund to feel financially stable. It’s entirely up to you and what makes you feel most comfortable and secure.
It’s a good idea to spend some time monitoring your daily expenses and thinking about how much of a safety net you might need to feel financially supported during an emergency. If you have a family, you must factor in your dependants and their particular financial needs.
List any significant expenses you already know are lurking on the horizon and think about how much additional cash you might need to save to cover them if you found yourself in a financial squeeze – like if you were to lose your job suddenly.
Also, keep in mind that the ideal size of your emergency fund may shift over time. A significant change to your circumstances – a new baby, for instance – may drastically change the amount of savings you might need to feel financially secure. Review the amount in your emergency fund periodically to see if you think it is still enough to cover your lifestyle.
How to create your emergency fund
Once you’ve decided on a suitable size for your emergency fund, it’s unlikely that you’ll be able to set aside all that money straight away in one go. An emergency fund is typically money that you save up over time.
Think of the amount as a goal you can work towards. See if you can identify a fraction of your salary that you can put towards your emergency fund. No amount is too small to get started. If you have some unnecessary expenses, see if you can cut them down to funnel some extra money into your emergency fund each week.
Many financial advisors also recommend that if you have any financial windfalls – like a tax refund or a pay bonus – you set all or part of this money aside in your emergency fund. This can help you reach your savings goals faster.
And remember, the more money you put away, the sooner you’ll be able to rest easy, knowing that you have the cash available to meet whatever financial challenges the world throws at you.
Learn More About Investing with The Motley Fool
Interested in learning more about investing? Then be sure to browse our "Investing Basics" knowledge hub, which we've created to help more people learn about the wonders of investing. It's just our small way of helping make the world Smarter, Happier and Richer.