Having an emergency savings fund is like having an insurance policy but without the need to pay monthly premiums. Your emergency fund is there to get you through any of the brick brats that life unexpectedly throws at you. It may only be when you encounter a financial emergency that the full value of having an emergency fund will hit home but the consequences of not having one can be very messy. Let’s look then at what an emergency fund is, why it’s so important, what amount you should have in it, and how you should go about creating it.
What is an emergency fund?
The name’s fairly self explanatory. An emergency fund is a pot of money that you can call upon immediately should the need arise. It is money that you will commit to set aside and not spend unless a real emergency crops up. However, you don’t want it to just sit there and not earn any interest so financial advisers would always recommend that individuals maintain their emergency fund within a high interest instant access savings account.
The “instant access” part is very important as you may need to withdraw the funds at very short notice. It’s therefore no good to have your money in a notice account that requires 90 days notice to access the money! As well as the term “emergency fund”, you will sometimes also hear it referred to as a “contingency fund” or a “rainy day fund”.
Why is an emergency fund so important?
Life is unpredictable and has a habit of throwing up nasty surprises from time to time. We only have to look at the news to corroborate this, as bulletins are awash with horrible reports of people losing their jobs or suffering personal injury or damage to property through all manner of freak occurrences.
We can guard against some of these unknown setbacks through purchasing insurance policies. However, it would be very expensive (and impractical) to cover ourselves from every eventuality in this way and we therefore tend to just make sure that we have some of the biggies covered, such as car insurance and home insurance.
In every day life, though, there are many other costs that can suddenly appear that we weren’t expecting but have to deal with. The presence of your emergency fund will hopefully enable you to speedily address the emergency in a relatively painless manner. The alternative, if you hadn’t had the foresight to save money, is that you might be forced to turn to a credit card, loan, or run up a big overdraft. These are all very costly solutions and a tightening of credit policy means you might not even have that lending option.
How much should you have in an emergency fund?
Advice differs on this but typically financial planners suggest that you set aside three month’s worth of your salary. During a particularly turbulent economic cycle you might decide to up the amount of money in your contingency fund but anything more than six month’s worth of salary is probably excessive. The trade off here is that you have to balance up your desire to protect yourself from unexpected costs with your desire to earn an above average return on your spare cash.
How should you create an emergency fund?
The first step to creating an emergency fund is to open an instant access savings account. It’s then a case of depositing funds into it until you are happy that the fund is large enough to meet your needs. Of course, many people may already have sizeable savings and it is okay to have both your contingency funds and your general savings in the same account. The key thing is that you must commit to keep the account funded to at least the minimum amount that you have determined is needed as your contingency fund. Some individuals may prefer, however, to keep their general savings and their contingency fund separate.
Setting up a contingency fund is one of the key cornerstones of financial prudence. You should look at have around three month’s worth of salary set aside in an instant access savings account. This money can then speedily be called upon in the event on an unforeseen emergency.