What Is an Emergency Fund?
An emergency fund is an account for funds set aside in case of the event of a personal financial dilemma, such as the loss of a job, a debilitating illness or a major repair to your home. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to draw from high-interest debt options, such as credit cards or unsecured loans.
Understanding an Emergency Fund
An emergency fund should contain enough money to cover at least three months of income, according to most financial planners. Note that financial institutions do not carry accounts labeled as emergency funds. Rather, the onus falls on an individual to set up this type of account and earmark it as capital reserved for personal financial crises.
A married couple who earns $108,000 annually after taxes should set aside a readily accessible minimum of $27,000 (three months) to $54,000 (six months) to address unexpected financial surprises. The funds should be highly liquid, remaining in checking or savings accounts. These vehicles allow quick access to cash for satisfying household expenses during an emergency situation.
Emergency Funds and Investing
Financial advisers view an investment strategy as a pyramid. A strong base is fundamentally important to support the levels of risk an investor bears as securities with varying levels of volatility layer over the foundation. Before an individual ventures into intermediate- or long-term investment vehicles, the establishment of an emergency fund is recommended as the first step toward creating stability and minimizing risk.
Stashing three or even six months’ income in a highly liquid account, such as a money market, should preclude the purchase of any instrument that holds risk to principal or requires lock-in periods during which penalties are assessed for early withdrawal. As more volatile securities sit atop above the base of savings accounts or Treasury bills, overall portfolio volatility is minimized and necessary access to risk-free capital is optimized.
Prudent advice should deter a new investor from immediately placing savings in an investment vehicle, such as a growth mutual fund, before that individual creates sufficient liquid capital on which to rely in the event of income loss. Growth funds, while less volatile than individual stocks, hold risk to principal that is best mitigated by increased time horizons. Furthermore, managed growth funds often charge a front-end sales load up to 5.75% or a contingent deferred sales charge (CDSC) against redemptions that would further impact principal needed in the event of an emergency.
- An emergency fund is a financial security for future mishaps and/or unexpected expenses.
- Financial planners recommend that emergency funds should typically have 3 to 6 months' worth of expenses.
Strategies to Set Up an Emergency Fund
Starting early is key to setting up an emergency fund because it helps you build up a comfortable cushion against unexpected emergencies (or mishaps) later in life. Getting a start on emergency funds is not complex. Here are two simple ways to begin saving for an emergency fund:
- Set aside a comfortable amount from your salary each month. This amount should be calculated keeping an eventual goal for savings that will contribute to your fund. As you move up (or down) through your career, you can revise this figure.
- Save the tax refund you receive each year. The tendency for most of us is to consider the tax refund as "extra" cash, which can splurged on luxuries. Instead of spending the tax refund, save it as a contribution towards your emergency fund.