Question: Is it really necessary to have an emergency fund? Francis via Facebook
Answer: Yes because emergencies happen! It is foolish to think that we will never undergo an emergency in life, and most of the time, emergencies cost a lot of money.
In my book No Nonsense Personal Finance, I wrote about setting up an emergency fund as the 3rd step to achieving financial security.
Before starting an emergency fund, it is best if you know how much you actually spend in a month.
Many people I know are clueless as to how much they spend monthly.
If you already have a monthly figure, you are now ready to start building your emergency fund. The rule of thumb for emergency allocation is somewhere between three and six months of your monthly expenses.
Three months is good, four months is better, five months will be great and six months is excellent.
Emergency funds come in handy for a variety of reasons: medical emergencies, loss of employment and so forth.
You should also be sensible in determining what an emergency is and what it is not.
A 65” flat LED TV that is on sale is definitely not an emergency.
Why should you set up an emergency fund? Here are three good reasons why you should:
1) Emergencies do happen
It is foolish to think that emergencies will not happen to you. As time goes on, you realize that things do come up that you have not planned for; and you’re going to have to provide for them. Things do happen, and they won’t happen at a convenient time.
2) Relieves stress
Having an emergency fund has an added bonus—Peace of mind! You will feel relieved because you no longer have to worry about most small emergencies. Once you get your larger emergency fund saved, you won’t have to worry about paying for most large ones either.
3) Risk reduction
When you have established an emergency fund (along with other important things like life insurance, nonlife insurance, and health insurance), you have a lot less risk of unfortunate things happening. You will also be less like to go into debt. In other words, you’re making sound decisions to plan for problems, before they actually happen.
I know that starting an emergency fund is not easy for others but this is definitely something we should prioritize. Personal finance icon Dave Ramsey suggests we do it by ‘baby steps.’ Set aside little money regularly into an emergency fund. Do it in stages like one week worth of expenses first, and then move to two weeks, to three weeks and so forth. Keep a piggy bank or an envelope for you to put your cash into it.
Here are some tips:
1) Keep your emergency fund in cash or near cash placements like savings, current, time deposits or Special Deposit Accounts (SDA). Do not invest your emergency funds yet as those are intended to be a buffer or a margin for your finances. Make sure that the deposits can be withdrawn quickly and without huge penalties.
2) Keep some of those funds in an ATM account, say two weeks’ worth. Emergencies do not necessarily occur during banking hours.
3) Once you have achieved an ideal six months emergency buffer, start investing in better yielding instruments like pooled funds (UITF, Mutual Funds), stock market or real estate because said instruments should perform better in the long run. If you keep all your money in low yielding deposits, its value will ultimately erode because of inflation.
Gear up for an emergency because it is the wise thing to do.
“A prudent person foresees danger and takes precautions. The simpleton goes blindly on and suffers the consequences.” —Proverbs 27:12, NLT.
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