What is an emergency fund and why do you need one?

 

“There's no harm in hoping for the best as long as you're prepared for the worst.”― Stephen King



Life is a journey full of unexpected twists and turns. While some of the surprises are nice, some are not. While we all aspire for happy surprises, it's also crucial to be prepared for the unexpected, particularly when it comes to your personal financial well-being. Unexpected circumstances can send people and households into a downward spiral of debt if you are unprepared.


One simple way to do so is to set aside a little sum of money for emergencies. Using our emergency fund, we will be able to deal with any unexpected income or spending shocks, such as job loss, medical problems, home/car repairs, and so on.


Liquidity is essential for surviving any income or expense shocks, because it allows us to buy enough time to recover. As a result, establishing an emergency cash reserve is an important step on the road to financial security.


How much emergency fund is sufficient?

Generally recommended emergency fund is between 3-6 months of worth of expenses. However, it may vary depending on one's specific circumstances, such as income level and income volatility, among other factors. A tenured professor with a regular/stable source of income, for example, may require a smaller emergency fund than a real estate salesperson with an unpredictable and variable income.


Second, by purchasing enough insurance or planning ahead for expenses that are predictable in nature, one can avoid or control some expected but unpleasant surprises.


Should you invest your emergency fund?

The goal of an emergency fund is to provide a cushion to cover any unexpected expenses. Investing in a highly liquid, low-risk asset class, on the other hand, will help you beat inflation and preserve the value of your money.

As a last point, I'd want to emphasise the importance of establishing an emergency reserve before allocating funds to financial goals. Because an emergency fund is designed to protect you from unanticipated circumstances, it should be prioritised.

Author: Ravinder Voomidisingh

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