For most young adults entering the workforce, the one piece of advice you hear most often is to start saving for a “rainy day”. Saving for an emergency fund is almost like a prerequisite for other personal finance goals -- since emergencies (i.e., medical or financial) are a fact of life.
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: 5 things to consider about debt management
How much money should you have in your emergency fund?
Your emergency fund should be able to cover at least 3 - 6 months’ worth of expenses. To determine this amount, calculate the sum of essential monthly expenses such as food, rent, utilities, insurance payments, etc.
Consider this example:
Then multiply your total monthly expenses by your desired goal (in months): $3100 x 6 (months) = $18,600. Therefore an emergency fund for 6 months would need a target amount of $18,600.
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 us assume that you have a monthly income of $4000, your monthly expenses as calculated above are $3100 and again, if your goal is to set aside $18,600 for an emergency fund of 6 months -- it will take you a little over 20 months to save for your desired goal.
Now, this might not be a long time for some, especially if you already have some savings set aside, however, for others this might be daunting. If you want to build your emergency fund in a shorter period of time, you’ll need to save more each month. This means you need to evaluate your lifestyle and make some loftier budget changes. Do you really need to upsize that McSpicy meal?
Read more: How to save more money
2. How much can you commit to saving each month?
Let us flip the switch. Your emergency savings target is still $18,600, 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 will need to commit $1240 a month towards your emergency fund.
If you can’t pledge this amount because of expense or income restrictions, consider waypoints on your journey. You could cut back on an expense even more (e.g., downsizing to a place with cheaper rent or finding additional revenue streams such as tutoring).
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 should you keep your emergency fund?
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 like UOB One or DBS Multiplier, which offer interest rates of 0.05% ~3.0% p.a., make sure to look at the complex conditions for opening certain accounts such as an initial deposit amount or withdrawal limits and fees.
Alternatively, you may consider parking your emergency fund into Endowus Cash Smart, a higher-yielding, low-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 savings
Emergency funds are to prepare you for accidents, so having your money ready when you need it most is critical. Risk-free instruments such as Singapore Savings Bonds and fixed deposits keep your rainy day funds up to speed with inflation and safeguarded.
A cash management account, like the Endowus Cash Smart Core portfolio which has a projected return of 0.8% to 0.9% p.a., allows you to grow your funds in a safe and low-risk environment without having to worry about the volatility and liquidity of your cash.
Why everyone should have an emergency fund
Building an emergency fund will help you secure your financial future. It will also help 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.