Emergency fund – in good times and bad times
Loss of work, longer sick leave, leaking roof, broken car or unexpectedly high energy ar-rears. If you do not want such relatively common problems to get out of hand and require unnecessary loans, you need to be prepared for them. The emergency fund serves exactly for this purpose. But how much should you “put aside “? Where should you keep the emergency fund? Is your current bank account sufficient or can you invest it?
Ján Tonka | Personal finance | 17. October 2019
The main reason why everyone should build and hold sufficient emergency fund is preparation for unexpected (negative) events. To money, however, it makes no difference for which purpose they will be used. The emergency fund may therefore also be used to take advantage of opportunities.
You will undeniably find it easier to think about changing profession when your entire existence does not depend on the next pay check from a job you hate with passion. Do you have a great idea and want to start your own business? Having enough cash in your account will surely make it easier to get started.
However, you can use the emergency fund (or at least part of it) also for sales in the stock market. While everyone will be panicking and saying that the end of the world is near next time the stock market fall, you can invest some of your saved money. Any decline in financial markets is an excellent opportunity to purchase in the long run. Over the next few months, you can gradually rebuild your emergency fund.
How much and where
In general, it is recommended to hold money in bank account to cover the total household expenditures for 3-6 months. So, calculate all your monthly expenses (mortgage, energy, food, car costs, loans, insurance, etc.) and multiply the result by 3 to 6, depending on how big of an emergency fund you perceive as adequate.
However, the topic of personal finance is always very individual and it is no different with the emergency fund. If you have a stable job in a prospective industry and in case of a loss of job you can easily get hired again under good conditions (doctors, IT specialists, etc.), there is no need to accumulate too much cash.
On the other hand, if you work in sectors that could be greatly threatened by the next recession (car manufacturers, ordinary bank clerk, etc.), you should be more careful and have more cash prepared.
It is important that this money is available at all times. However, the ideal place for a emergency fund is not your current account from which you pay all of your current expenses. You could easily slip away and spend it on everyday expenses. Who wouldn't be tempted to buy a new wardrobe piece, a better phone, or go on a more exotic holiday when you have a few thousand euros in your account to spare.
Instead, set up a separate (ideally saving) account for it. Most banks now offer the possibility to open one or even more savings accounts free of charge in addition to a current account. The money deposited in these accounts will, however, not earn you anything, but that is not their goal.
The emergency fund that you hold in your bank account is an insurance. Not an investment. And do you know what the insurance does? It costs you money. Whether in the form of a direct payment to the insurance company or like in this case in form of lost profit and depreciation due to inflation.
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You can invest part of it
Most of the money is kept by the majority of people in their current account in the bank, where they are depreciated by 2-3% each year due to inflation. One euro held in a current account for 10 years thus loses on average one third of its value.
Therefore, it is not worth holding too much money in your bank account. You can also invest part of the emergency fund. A conservative portfolio consisting of 50% equities and 50% bonds is also capable of generating attractive returns in the medium and long term. Over the last 5 years, you would earn approximately 4.8% per year.
Even a portfolio that consists of 30% equities and 70% bonds would have earned you almost 3.2% per year over the past 5 years, surpassing inflation and preserving the purchasing power of your money.
Start at the beginning
Wealth means freedom. The freedom to change work, housing or just to solve everyday problems without excessive stress. You will find it easier to face problems when you have money in your account set aside specifically for this purpose. Thanks to the emergency fund, potential disasters become only inconveniences that do not endanger your living.
At the same time, the emergency fund is the basis on which you can build your financial assets. The right investment must be long-term. However, investing long-term without a short-term reserve is nonsense. Only after its creation should saving for retirement, children or better housing start.
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You do not want to get into a situation where you will lose your job due to the financial crisis and you will be forced to withdraw money from your long-term investments at a time when the markets will temporarily fall. The emergency fund protects not only you, but also your long-term financial assets.
If you do not have an emergency fund yet, start to deposit at least 10% of your net income as soon as possible. In one year’s time, you will save 1,2 times of your monthly salary and in less than 3 years you will create a reserve of almost four monthly net salaries. Don't postpone it until later, because by then it might be too late.