Emergency Fund: What is It and Why You Need One

There is not one person who can claim that they have been well prepared for anything life has thrown at them so far. Our journey on this Earth is an unpredictable one with many twists and turns. Circumstances can change in an instant and emergencies can arise out of the blue.

During times of adversity and hardship, having an emergency fund can be a lifesaver. Having the habit to stash some money away for emergencies is critical for your financial security.

There is no sure-fire way to plan these savings but there are some tips that can help.

1. What is an Emergency Fund?

An emergency fund is a sum of money you put aside in the event of unforeseen circumstances. This can include things like medical emergencies and unexpected bills. It can also come in handy to keep up with essential expenses if you experience a drop in income.

An easily accessible emergency fund can prevent you from going into debt or upsetting your long-term saving goals. It is important to note that emergency funds are not for anything other than essential, last-ditch needs. A sudden vacation or buying the latest gadget are not valid reasons to dip into these savings. You should only access these funds when:

  • You lose your job or your income is reduced substantially.
  • Your house needs major repairs due to unforeseen damages.
  • You have unexpected medical or dental expenses.
  • Your car needs major repairs.
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2. How Much Should You Save in an Emergency Fund?

Your savings depends on your lifestyle and your income. The expert opinion is that you should save at least three to six months of your salary in your emergency fund. People who want to be extra careful are told to save enough to account for all essential expenses for six months.

One thing is certain, the larger your emergency savings, the better your financial security is. The exact numbers vary from person to person, depending on their family size and cost of living.

For example, for a family of four living in Toronto, it could be expected to have an emergency fund of up to $48,000. This is an estimate, however, and it can fluctuate if you live in a cheaper area and are careful with your money.

These figures may seem intimidating at first, but the important part is to keep saving what you can and it will all add up. Even the extra $500 in an emergency can be a big help.

3. What Qualifies as an Emergency?

A financial emergency is an unexpected but necessary instance where you need cash in hand to avoid going broke or in debt. It is something that happens circumstantially and is rare.

There are many reasons why you might need to dip into an emergency fund, some of the most common ones include:

  • Medical and dental emergency for your family or pets
  • Car emergencies in case of accidents or repairs
  • Home repair emergencies in case of unexpected damage caused by flooding etc.
  • Losing your job unexpectedly
  • Loss or damage to essential property due to natural disasters
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Whenever you think you should dip into your emergency fund, it is important to ask yourself 3 main questions.

  1. Is this expense unexpected?
  2. Is this expense necessary?
  3. Is this expense urgent?

The more you agree with these questions the more valid it is to spend your emergency fund.

4. What doesn’t Qualify as an Emergency Expense?

There are some instances where you may feel justified in spending your emergency fund, but in reality, they are things that could have waited, been managed better, or avoided. Some of these include:

  • Tax payments on your property
  • Going for a vacation
  • Having a baby
  • Getting a new pet
  • Getting a new car
  • Getting married
  • Recurring car expense like routine maintenance
  • Down payments on new property
  • Splurging on a sale

5. How to Build an Emergency Fund

While they all require saving money, building an emergency fund is different from buying life insurance, having a retirement fund, or investing in stocks. When you invest your money, it is no longer liquid and is tied up in stocks or mutual funds. Investing is all about increasing your wealth in the long term while an emergency fund is something you have instant access to.

The following points can help when starting an emergency fund:

  • AnaIyze your expenses to identify the amount of money you can put away as savings.
  • Set aside a percentage of your savings each payday or month.
  • Set up a savings account that is tax-free or provides high interest.
  • Make sure to disconnect the account from a debit card to discourage spending.
  • Pay yourself first.
  • Automate the payments so it becomes a passive activity.
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6. Where You Should Keep an Emergency Fund

The purpose of an emergency fund is to have liquid cash on hand at a moment’s notice. This means you should be able to access your money without any hassle or hidden fees. Taking all of this into account, generally, the best place to keep your emergency fund is in a high-interest savings account.

Many banks offer savings account options with no minimum balance requirements or monthly fees. They also offer the ability to have competitive interest rates that will help you keep up with inflation. Since there are no fees, you are free to move your money as you please.

7. Where You Shouldn’t Keep an Emergency Fund

While stocks and mutual funds are brilliant for generating wealth, they are long-term options and not suitable as an emergency fund. These markets tend to fluctuate daily and you may end up losing money if you need to liquidate your assets in a hurry.

Every other option either has complicated withdrawal and contribution limits and doesn’t provide any interest. Sure, you could leave money under the sofa, but it will probably get damaged.

Following these points will better equip you with how you approach savings. Sure, the process can be hard, but it doesn’t have to be complicated. Making sacrifices now will pay off big time in the long run.

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About FinanceGAB

Ajeet Sharma is a financial blogger and I am blogging since 2017. Financegab is a personal blog dedicated to personal finance. The main aim of this blog to help people to make well-informed financial decisions.
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