As we’ve explained on other occasions, everyone, whether individually or as a family, should have an emergency fund to deal with life’s unexpected events and setbacks. But what is an emergency fund in personal finance? How much money should it hold? And how long should it cover us?
What is an emergency fund?
It’s an amount of money that we keep set aside but available (in liquid form) to cover unexpected events and emergencies in our finances, so that if we stopped receiving income tomorrow, it could cover our fixed expenses for a few months. When we say the emergency fund must be liquid, we mean that we can get hold of it from one day to the next without losing purchasing power or being penalised for withdrawing the money.
In other words, if money meant for the emergency fund were held in shares and we needed it at a time when those shares had lost value, we’d be losing money when we cashed them in. So it must be completely liquid. See the definition of liquid and illiquid assets.
How long should the emergency fund cover you?
Work out the expenses and financial needs you have each month: electricity, water, mortgage, food and so on. The emergency fund should be able to cover those expenses for 6 to 12 months if we received no income during that period, without having to sell any of our assets.
It’s estimated that more than 70% of people don’t have enough savings to cover more than 3 months if their income stopped tomorrow. And that’s a sign that your finances aren’t healthy.
See also: How a lack of money cripples your brain when it comes to personal finance
Not having an emergency fund, together with heavy debt, is among the biggest mistakes we make with our personal finances.
How much money should we keep in the emergency fund?
People always talk about a minimum of 3,000 or 6,000 euros, but if we go back to the previous point, the emergency fund will depend on our current lifestyle. Some families live so frugally that they could get by for 6 months on just 3,000 euros. Other families have fixed expenses such that a 5,000 euro fund wouldn’t even last them two months.
So rather than setting an amount of money to save in the fund, we should set the length of time it has to cover us. For a proper emergency fund, and finances prepared for economic disasters, once we’ve worked out all our fixed expenses it should be able to cover us for at least 6 months.
The main reasons to have an emergency fund
1. The psychological factor in the face of disaster
When we talked about how to deal with a personal financial crisis, we explained that everyone will go through that situation at some point in their life. The first step in facing it was to avoid panic and think calmly and intelligently. You’ll hardly manage to avoid panic if, the moment you suffer a setback, your financial problems come crashing down on you within weeks because you’re living hand to mouth.
You have to avoid making desperate decisions, because they rarely turn out well. An emergency fund will give you that peace of mind and stability, as well as the patience you need to work out a strategy.
See also: The worst money mistakes people make in every decade of their life
2. Losing your job
To lose your job, all you need is to have a job. Some people see it coming, while others are caught by surprise. When our finances are going well is precisely when we should look for alternative sources of income and plan our emergency fund. Remember that sooner or later things always get worse, and the only way to avoid the impact is to prepare for it in advance.
See also: How much we should save each month to be financially responsible
3. Factors beyond our control
The global or national economy can make our bills go up. We may see huge price rises in basic goods, electricity, water and so on, and this may coincide with a pay cut from our employer to avoid laying off staff.
Our income goes down and the cost of living goes up. That’s when Murphy’s laws start to kick in, and our emergency fund can be the antidote that limits the damage.
4. Unexpected car and home repairs
Our car can break down at any moment, and the repair can be expensive. In more extreme cases, we might have to replace it altogether. Likewise, at home we can face anything from a small breakdown (the boiler, the water heater, a hob, plumbing problems…) to major disasters that insurance doesn’t cover. The emergency fund will save us from having to borrow to pay for those repairs or disasters.
5. Illness
If you’re self-employed, an emergency fund is a priority for you, because being ill will cost you money. Likewise, for pet lovers, vets aren’t cheap. And if we get a call saying that a relative on the other side of the country has died and we need to go to the funeral, the last thing we’d want to worry about at that moment is the cost of the trip.
In short, an emergency fund won’t let us avoid certain problems or disasters that come up unexpectedly, but it will help keep that problem from turning into another one. Because money, though some people believe otherwise, helps a great deal, in good times and in bad.
Further reading
Featured image: Jsalatas, CC BY-SA 4.0, via Wikimedia Commons.
