Savings funds are pre-planned savings for future expenses, such as saving for university education or a sabbatical leave from work. In comparison, emergency funds are meant for unexpected situations which require a sizeable amount of money.
If you’re not too familiar with the idea or how to build and manage an emergency fund, this article is your guide on how to get started.
Why do you need an emergency fund?
An emergency fund is a pool of money set aside for expenses from unexpected events such as a hospital bill from an injury or the financial burden from a sudden job loss. It acts as a crucial alternative to having to depend on credit cards and personal loans (which might lead you into debt).
Likewise, if you already suffer from debt, an emergency fund acts as a financial buffer from falling further into debt.
Read more: Five things to consider about debt management
Real-life situations that require an emergency fund
- Loss of job from retrenchment
- Medical emergency of yourself or loved ones
- Emergency home repairs
How much money should you have in your emergency fund?
Your emergency fund should be able to cover at least three to six months' worth of expenses. To determine this amount, calculate the sum of essential monthly expenses such as food, rent, utilities, insurance payments, and so on.
Here's an example:
Then, multiply your total monthly expenses by your desired goal (in months): $21,000 x 6 (months) = $126,000. Therefore an emergency fund for six months would need a target amount of $126,000.
For those with a larger family, or self-employed individuals with variable incomes, it is recommended to save up to 12 months or so. You would want to prioritise saving up enough for the number of people you help support or for the unforeseeable circumstances of what your month-to-month income is like during an emergency.
How to build an emergency fund
There are two angles you can consider from when getting started on building your rainy day fund:
1. How long do you want to take to reach your goal?
Let's assume that you have a monthly income of $30,000, your monthly expenses as calculated above are $25,000, and your goal is to set aside $126,000 for an emergency fund that can cover you for six months of expenses — it will take you a little over 25 months to save for your desired goal.
Now, this might not be a long time for some, especially if they already have some savings set aside. However, this might be daunting for others. If you want to build your emergency fund in a shorter period of time, you’ll need to save more each month. That means you have to evaluate your lifestyle and make some loftier budget changes. Do you really need to upsize that McMuffin meal?
2. How much can you commit to saving each month?
Let's flip the switch. Your emergency savings target is still $126,000, but now you want to save up for it in the span of 15 months, to get it out of the way so you can focus on other financial goals. This would mean you have to commit $8,400 a month towards the emergency fund.
If you can’t pledge this amount because of expenses or income restrictions, consider waypoints on your journey. For instance, you could cut back on an expense even more, such as by downsizing to a room with cheaper rent or finding additional revenue streams such as private tuition assignments.
Set up a structured monthly payment plan
This will help you create the habit of saving regularly and hold you accountable. It makes the task less daunting if you automate transferring a certain amount each month to your rainy day fund each time you get paid. Staying on track is key to setting up your emergency fund sooner rather than later.
Where to keep your emergency fund
There are many different options available for you to keep your emergency funds in, such as:
- Cash
- High-yield savings account
- Fixed deposits
- Cash management solutions, such as Endowus Cash Management Model Portfolios
- Insurance saving plans
Liquidity of emergency fund
While the whole point of an emergency fund is to be as liquid as possible, stashing a wad of cash in your sock drawer is never a good idea. Instead, build your emergency fund passively, using a “pay yourself first” method by maintaining a consistent payment contribution every month into an easy access high-interest savings account. Another popular option is a high-yield cash management account — one that is low-risk and earns enough interest to keep up with inflation.
Interest rates from your emergency fund savings
When looking for high-interest savings accounts, make sure to look at the terms and conditions — such as an initial deposit amount or withdrawal limits and fees — for opening certain accounts.
Alternatively, you may consider parking your emergency fund into Endowus Cash Management Model Portfolios, a high-yielding, lower-risk cash solution to help you grow your rainy day savings passively. With a zero lock up policy, you can access your funds anytime for emergencies or accidents.
Risk and volatility with your emergency fund
Emergency funds are meant to prepare you in the event of unforeseen circumstances such as accidents, therefore having your money ready when you need it most is critical. Risk-free instruments such as fixed deposits keep your rainy day funds up to speed with inflation and safeguarded.
Before using your emergency fund, you should also consider carefully if you should tap on to what is potentially your last lifeline. Some questions that you should ask yourself include:
- Am I able to defer or spread out the payment?
- How much of my emergency fund am I using?
- How long will it take for me to rebuild this emergency fund?
- Can I ask for earlier payment of my salary to help me with my finances?
Why everyone should have an emergency fund
Building an emergency fund will help you secure your financial future. It will also provide peace of mind and protect you from debt created by the unexpected.
Being deliberate and committed with your emergency fund can effectively support you with other financial goals.
To get started with Endowus, click here.
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