This is the first post in our new personal finance series, hence the shiny new picture! Trading and investing are both vital tools on your journey to financial freedom, but you need capital to invest. This series will explore various aspects of personal finance to ensure you have enough capital to trade and invest successfully. The first topic we will cover is the emergency fund.
What is an Emergency Fund?
An emergency fund is exactly what it sounds like. It is a fund dedicated to covering the costs of any unforeseen expenses you may encounter. It’s not as glamorous as a trading account or an investment portfolio, but it can be even more important. A study by the Federal Reserve conducted in 2018 found that nearly 40% of Americans would struggle to cover an unforeseen bill of $400 without borrowing. $400 is not a large amount by today’s standards, the fact that nearly 4 in 10 people would struggle to pay it is eye-opening.
An emergency fund should only be used for emergencies or unforeseen bills. It should not be used to fund new purchases (unless necessary). A good example would be a new car. If your old car is functioning well and doing its job you should not use your emergency funds to buy a new one. If, however, your old car has gone past the point of repair and a car is an absolute necessity for you, using your emergency fund to purchase a new one would be acceptable.
How Much Should You Have in Your Emergency Fund?
There is no hard and fast rule here, the amount needed will vary greatly depending on your situation. What we can give is a good starting point. We recommend having enough money in your emergency fund to cover six months worth of expenses. This will allow you to continue to live as you live today even if you lose your job, six months should give you plenty of time to find a new one.
Six months of expenses can seem like a daunting amount of money to put aside, so let’s break it down into an easy process to follow.
- Find out how much you need to save. Make sure you include all of your expenses in your calculation including mortgage/rent, food, phone bills etc. If your expenses tend to be fairly consistent from month to month, simply take your expenses for the last month and multiply this amount by six. If your expenses tend to vary month to month, take the highest number form the last six months and multiply that by six. Emergency Fund Requirement Example: €12,000.
- Take the amount found in step one and deduct any current savings you have. Only deduct these savings if they are not earmarked for another purpose. Let’s assume you have €2,000 sitting in a savings account for no particular purpose. Emergency Fund Requirement Example: €12,000 – €2,000 = €10,000
- Take the final amount and get started! By dividing your required amount by the estimated amount you could save each month, you will get a ballpark amount of time required to save the amount. Example: Ability to save €500 per month. €10,000 / €500 per month = 20 months.
Building an emergency fund is not an overnight endeavour, as with all worthwhile things it will take time.
Where Should You Keep Your Emergency Fund?
The primary concern when deciding where to put your emergency fund is access. The secondary concern is your return on the money. There is very little point tying up your emergency fund in a long term bond. An emergency is, by its very nature, unexpected. You do not know when you will need the money so fast access to it is key. Getting a return on your money is nice but it should not determine where you put your money.
The usual place for an emergency fund is a savings account. Providing you choose wisely, you will have immediate access to your money. Although the returns may be small, by shopping around you should be able to find a high-yield savings account.
Use an Emergency Fund Wisely
When you have saved the required amount to cover six months of expenses, pat yourself on the back! The job isn’t complete just yet though. At this point, it is imperative that you do not touch your emergency fund for anything other than a genuine emergency. Is your friend giving you a sweet deal on a motorbike? Great, but don’t use your emergency fund to purchase it. Is your house in need of painting? By all means, paint it, but don’t use your emergency fund to fund it.
I’m not going to insult your intelligence with any more silly questions, but the point remains valid. Don’t be tempted to spend the pile of cash you have set aside!
Enjoy Some Peace of Mind
The greatest benefit of an emergency fund is the peace of mind it provides. Knowing you have enough spare cash to be able to live comfortably for six months may open some unexpected doors. Having that cushion there may allow you to pursue your side business with more vigour, it may allow you to try out a new career completely. It will also allow you to trade and invest any surplus money you may have at the end of the month. Knowing you have a six-month buffer can have a positive effect on your decision making.
If you are interested in personal finance and wish to further your financial goals, having an emergency fund is a no-brainer.
The Stoic Trader