You have a stable job, pay your bills on time, and took two vacations to Europe and South Africa last year. Why prioritise building an emergency fund when you could be saving for your next vacation?
Here’s why: No matter how financially prepared you think you are, life has a funny way of throwing curveballs you would never expect. You could be retrenched unexpectedly, or be faced with a medical emergency. These “unexpected expenses” are the reason financial experts typically recommend setting aside three to six months’ worth of your salary for your emergency fund.
What is an emergency fund?
An emergency fund is simply money you set aside for when emergencies strike and you need money to tide you over financially. It is not used for expenses like a new car or a home down payment. Rather, the money should be used for emergencies only (the Prada bag you’ve been eyeing going on sale does not count).
Why is it important?
There are many reasons why you should work on growing your emergency fund if you don’t currently have one. We highlight the top three reasons why.
Get through challenging times without worrying about money. Imagine if you have to undergo an unexpected major surgery with a long recovery period. How are you supposed to cover your expenses when you’re physically unable to work for that period of time? Or perhaps, you’re the sole breadwinner in your family and your position has suddenly been made redundant. How will you and your family cope?
A well-prepared emergency fund helps you deal with these situations while you get back on your feet. If you’ve set aside three to six months of your salary, that goes into paying for your living expenses when you’re unable to work or in between jobs. As you deal with the emergency at hand, it’s a powerful assurance knowing you can still pay your bills and put food on the table.
Avoid dipping into your investments. Keeping all your money in your savings account can cost you, but so can tying up all your money in investments. Without an emergency fund, you may be forced to liquidate some of your investments at short notice to pay for unexpected expenses. You may have to sell your investments at a bad time – when the value of your portfolio has fallen significantly, or when the market is just beginning to recover. Either way, you’ll be converting a paper loss to a permanent loss by selling your investments prematurely, and missing out on any potential recovery.
Avoid going into unnecessary debt. Having adequate emergency savings can prevent the need to turn to debt to cover emergency expenses. If you use a credit card to pay for those expenses but cannot afford to make a full repayment, the debt can snowball. Even if you only pay the minimum sum, take note that interest is charged daily on the outstanding amount, and any interest not settled by the next payment date will also incur interest charges. Your emergency fund reduces the likelihood of you taking on additional debt, which helps make a challenging situation a bit less stressful.
How much to save in your emergency fund
At Syfe, we typically suggest keeping three to six months’ worth of your take-home pay in your emergency fund. That said, there is no set amount for everyone. How much money to set aside depends on your lifestyle and financial situation.
Generally, a larger emergency fund is recommended if you’re facing more uncertainties in your financial life. A freelancer may feel more comfortable with six months (or more) of their salary as emergency savings. Someone who works 9 to 5 in a government job may think three months is enough.
As you consider what amount of emergency savings works best for you, think about how difficult it would be for you to replace your existing income if you lost your job. If you think jobs in your field and salary-level could be competitive, consider saving more for a greater peace of mind.
That said, there’s no need to stress out about saving months of living expenses overnight. If you don’t have an emergency fund, steadily work your way up by starting a smaller fund first. It could be just $1,000 for now, but with diligent saving, you can grow your emergency fund to what you need it to be.
Where to put your emergency fund
Keep your emergency fund in an account you can withdraw from anytime you need. High-yield savings accounts are a good option. It also makes sense to keep your emergency fund separate from your savings or checking account. This way, you won’t be tempted to tap your emergency savings for daily purchases.
Think you may not have the financial discipline to contribute to your emergency fund regularly? Set up automatic bank transfers so a portion of your paycheck goes towards it. This will help your emergency fund grow steadily each month.
Setting aside an emergency fund is one of the earliest steps you should take to secure your financial future. Once you’ve that in place, it’s time to invest and grow the rest of your savings. Wondering what’s the best way to do that? Here’s everything you need to know about passive investing.