Emergency Savings Account is a separate account set aside to cover expenses that may arise as a result of unforeseen circumstances like loss of job, or medical emergency. It shouldn’t be seen as part of long term savings plan for things like a new car, college tuition or vacation.
The COVID-19 pandemic has further emphasized the need for an emergency fund as households with no financial cushion may end up with disastrous consequences and even those who have some emergency fund may realize its not enough.
Starting an emergency fund requires having a budget to track income and expenses. A financial plan would be incomplete without an emergency fund but its also important to know how much to save, where to save and when to use it.
How Much Should Be In Your Emergency Savings Account ?
The golden rule of emergency funds is to have at least three to six months of necessary household expenses. Necessary expenses are those that can’t be avoided, like rent or mortgage, transportation, utilities, food and medicine. Expenses like cable subscription or gym membership may not be considered necessary.
In a household that enjoys at two or more steady streams of income , then three months of expenses would be considered fair enough. But if you have a single stream of income, your self employed or working on commission basis, then at least six or more months of expenses cover with be considered adequate.
It pays to err on the side of more emergency fund rather than less, as there is nothing too wrong with saving more money. However, having too much stashed up in an emergency fund may mean losing out on opportunities to invest and earn more money. A regular savings will yield about 2% interest but there are other investment outlets that could bring in many time more.
Where Should Emergency Savings Fund Be Kept ?
Emergency funds should be liquid and readily available but shouldn’t be kept where there is too easy access as this invites temptation – like a shoe box at home. A good place would be an account where there is no risk of loss and you can access whenever required, in addition to earning some return that preserves it against inflation. An online savings account would be a good place to start.
IRA, mutual funds, stocks and certificates of deposit are less liquid, carry some investment risk, in addition to having withdrawal penalties. These type of accounts should only be used with careful planning and money should still be allocated into liquid accounts for urgent expenses.
When should you spend emergency savings?
An emergency fund can be used to cover expenses arising from a surprise event that requires urgent attention. Examples include, car /home repairs where there is no warranty or insurance, or a medical emergency.
It could also be used as a buffer where there is job loss or significant reduction income.
In tapping into your emergency savings, its important to evaluate your total financial situation, the duration of the emergency and the resources you have at your disposal.
These fund should be spent on necessary expenses and not discretionary ones.
Necessary expenses include the likes of Water, Electricity, heat; rent or mortgage and car payments; health care costs, food, insurance and debt payments. Discretionary expenses are those you can do without like other entertainment costs, cable subscription; restaurant spending; shopping; savings contributions etc.
Comprehensive planning is required to make emergency funds last as long as possible. Planning will lead to reviewing all monthly expenses in order to cut or reduce where possible. It could also bring up income generating opportunities like selling unused items or offering personal services.
Emergency funds provide a soft landing during unpredictable moments or hard times. People who have emergency savings account always come out better during such moments than those who don’t.