Emergency fund – the first checkpoint on your savings journey
Unemployment, longer incapacity for work, pandemic, leaking roof, broken car or just unexpectedly high energy arrears. If you don’t want the problems that life brings to get out of hand and require you to take out unnecessary loans, you need to be prepared. 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?
Juraj Hrbatý | Personal finance | 20. May 2020
This blog is an update of the article “Emergency fund – in good times and bad times” from 25.6.2019 and many of us participated in its editing.
The main reason why everyone should build up and hold a sufficient emergency fund is to be prepared for the unexpected (negative) events. Unfortunately, you don’t know when such a situation may occur, you don’t know how much money you will need and you don’t know how long it will last.
Significant need of an emergency fund materialized also during the COVID-19 pandemic, when tens of thousands of people lost their income and jobs, which had seemed stable a month before, literally over night.
You will learn more about what a proper emergency fund should look like in this blog:
- what a proper emergency fund should serve for,
- how big should the emergency fund be,
- why you don’t have to create an emergency fund only on your bank account,
- why is it necessary to create an emergency fund by investing,
- whether emergency fund means freedom in making decisions,
- why is the emergency fund the cornerstone of any investment
What should a proper emergency fund cover?
A good emergency fund should cover, first of all, unexpected expenses – i.e. those that you cannot anticipate today. We don’t have a crystal ball to tell you what life will bring you, but in general we can list a few basic life situations when the emergency fund should come in handy:
Job loss – no one is irreplacable, whims of your boss, economic crisis, pandemic, etc. It’s quite possible that unemployment allowance (if you get one at all) won’t save you, and the lack of income in your family could hurt a lot.
Disease – no one is invulnerable. Even if you have been healthy all your life, a day may come when you get sick or someone close to you gets seriously sick and you will need to take care of them. State benefits in such cases, as incapacity for work or leave to care for a family member, will definitely not replace your income.
Misfortune – it doesn’t discriminate. Natural disasters, accidents, broken devices and many other events occur in each of our lives. Are you financially prepared for them?
Many of you are now thinking “I guess insurance deals with these things”. Insurance companies have been exploiting our fear for a long time, making money off the fact that a large group of people can be insured for an event that only happens to a small group of people.
Therefore a proper manager should think differently. Instead of paying insurance that you may not even need, build assets that will cover any loss of income or unexpected expenses. Most of you probably won’t even need the emergency fund and you’ll have enough money left.
However, we should also mention positive aspects of the emergency fund building. The emergency fund can also help us to take advantage of opportunities. After all, money couldn‘t care less what purpose you use them for.
Surely, it will be easier for you to think about switching jobs when your whole existence doesn’t depend on the next paycheck from a job you hate wholeheartedly. Do you have a great idea and are you thinking about starting your own business? Getting started is easier with enough cash in your account.
How big should the emergency fund be?
There is a lot of situations that may come up throughout your life. A good emergency fund should be neither too small nor too big. If it’s too small it lacks relevance because you will not feel secure enough. In case you need it, it just won’t be enough.
If it’s too big, it will not be convenient because the money that you have to spare will not earn you any further profits. The emergency fund should be invested more conservatively and, therefore, its return will be lower.
In general, it is recommended to create an emergency fund covering the total household expenses for the period of 3-6 months. Alternatively, the emergency fund should cover the income of the family breadwinner, in case of outage of their income, for 3-6 months.
So, add up all the monthly expenses (mortgage, energy costs, food, car costs, loans, insurance and others) and multiply the result by a number on a scale of 3 to 6, depending on what amount in the emergency fund would satisfy you.
The easier way can be determining the amount of your net monthly income, after tax and levies, you receive monthly on your account. In Finax, we recommend that you create an emergency fund of six monthly net incomes.
However, the topic of personal finance is always very personal and it is no different in case of the emergency fund. If you lose your job in a promising sector you will be able to get a job again easily and under good conditions (doctors, IT specialists, etc.), there is no need to accumulate too big of an emergency fund.
On the other hand, if you work in a sector that could be, to a high degree, threatened by another pandemic or recession (automakers, regular bank clerks, etc.), it si appropriate to be more cautious and to have more money in the emergency fund.
Why you shouldn’t create an emergency fund only on your bank account
It is important that the emergency fund be available at any time. However, your current bank account, which you pay all your regular expenses from, is not the ideal place for keeping an emergency fund. You could easily slip into spending it on your everyday expenses. Who wouldn’t be tempted to buy a new piece for their wardrobe, a better phone, or go on a more exotic holiday when you have a few thousand euros just lying around?
The emergency fund you hold in your bank account is, in a way, an insurance. Not an investment. And do you know what an insurance does? It costs you money. Whether in the form of a direct payment to the insurance company or, in this case, in the form of lost profits and depreciation as a result of inflation.
The average Slovak holds most of their money in current bank account, where money depreciates every year by 2-3% due to inflation. Thus, 1 euro held in a current bank account for 10 years will, on average, lose a third of its value.
Emergency fund kept in the bank should amount to no more than 1 or 2 monthly incomes and you should have a special savings account set up for it, which most banks offer as a free complementary account. Build up the remaining emergency fund by investing.
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Why do you need to build up your emergency fund by investing?
Due to inflation it doesn’t pay off to keep too much money in your bank account. You should build up the larger portion of the emergency fund by investing. Even a conservative portfolio comprising 50% equities and 50% bonds can produce interesting returns in the medium and long term. Over the last 15 years (also including the 2008 financial crisis and the slumps caused by the COVID-19 pandemic) it would have earned you about 5.2% a year.
Even a portfolio with a 30% share of equities and 70% of bonds would have earned you 4% a year over the past 15 years, thus overcoming inflation and preserving the purchasing power of your money.
Warning: All data relating to the historical development of the Finax portfolios is modeled and based on data back modeling. We described how to model historical performance in How do we model the historical development of Finax portfolios?. Past results are not a guarantee of future returns and your investment may result in a loss.
Emergency fund equals freedom in decision-making
Everyone who has already built up a sufficient emergency fund would certainly agree with me. Wealth equals freedom. Freedom to change jobs, housing or to solve day-to-day problems without any futile stress.
It will be easier for you to face what life brings your way knowing that you have a certain amount of money put aside exactly for this purpose. Emergency fund makes the potential catastrophic scenarios look like mere inconveniences which will not pose a serious threat to you.
Many people are not aware of this aspect but the stress caused by a lack of money is one of the main causes of stress for households worldwide, especially nowadays, with the whole world living in the „fast lane“.
Emergency fund as the cornerstone of investing
Emergency fund also represents a bedrock for your financial assets. Proper investment is a long-term investment. However, long-term investment without a short-term emergency fund just doesn’t make sense. Saving for your pension, children or a better housing should ensue only after you have built up your emergency fund.
That’s why we, in Finax, have been recommending to set the emergency fund as your first investment goal ever since the beginning. It should serve as a base for your future investments and you should build up the emergency fund while working on your other financial goals that are important to you.
You don’t want to get into a situation when you will be forced to use the funds in your long-term investments due to loss of job during the crisis, with the markets in a temporary slump. Emergency fund not only serves to protect you, but also your long-term financial assets.
If you don’t have an emergency fund yet, start saving at least 10% of your monthly net income as soon as possible. In a year this will amount to a 1.2 times your monthly salary and you will have built up an emergency fund equal to 4 monthly salaries in fewer than 3 years. Don’t put this off until later - it might be too late.