Here’s a thought… European Union leaders came together a while back to set up an emergency fund for Greece. Wait a second… you don’t set up an emergency fund when an emergency happens! You set up one way before it happens!
Let’s take a page from this important history lesson in fiscal prudence and put our knowledge of crisis management to use! “It’s all about crisis management.”– that’s what my old boss Jonty Cross at Merrill Lynch taught me at my first job. Unfortunately, it took me a long time to learn that lesson! But it’s never too late to learn. Here’s what you’ll learn about emergency funds:
- What is an emergency fund?
- Why do you really need one?
- How much should you contribute (The Math)?
- How do you start one?
- What should you do if you’re in debt, do you start one?
- But I have a credit line / over draft / insurance!
- What does it feel like to have one?
What is an emergency fund?
An emergency fund is simply a set aside amount of cash for living expensesin case of emergency. What is or isn’t an emergency is up to you to decide. In my humble opinion, buying an iPhone is not an emergency (get the drift!). Don’t fool yourself, you know what an emergency is! This fund should be available to you, when you’ve lost your main source of income or when some extraordinary survival threatening expense pops-up.
Why do you really need an emergency fund?
Let me put it very bluntly: Shit Happens! I’m sure Louis Pasteur was thinking the same when he said, “Chance favors the prepared mind”. The one thing you can expect in life, is the unexpected to happen.
And that’s basically why you need an emergency fund. You need to prepare for emergencies in life, they are generally things that are not within your control, like job loss, serious medical condition, death of someone you depend upon, house collapse, some major accident or some worst case scenario. Wealthy people all agree that having a emergency fund is a necessity.
That’s probably because an emergency fund gives you a sense of confidence, a sense of security, a safety net or blanket that you will overcome and manage the crisis situation. You’ll be able to take better decisions, and not hasty ones that you’ll regret later – and wealthy people have the luxury of time. Also, great investors know the importance of risk management – an emergency fund is just that, and how much you risk you are comfortable with.
How much should you contribute or save (The Math) to the emergency fund?
There are plenty of ‘experts’ on this one single key question. And there’s no consensus. But here’s what I’ve done in real life: 12 months of my average current expenses – that’s around USD 2,000 per month. I have my criteria, you should have yours. The math for me was simple, I spend half of the USD 2,000 on house rental. I don’t really try to live frugally, but I know if an emergency happens, depending on its nature – I’ll be able to reduce x, y and z (discretionary) expenses. And that’s if I stay in Bahrain, if I head back to India – my expenses fall drastically to a fraction of that.
In other words, to each his own. You needn’t follow a 12 months or 9 months criteria, just do what you’re comfortable with, taking into consideration a number of factors: your education, your work experience and your marital status, not to mention the needs of your dependents, spouse, children and an estimate of how long a hypothetical crisis might last.
When you work your monthly average, also take into consideration the essentials of life or as we call it in India – roti (bread), kapda (clothing), makaan (house). Work out your monthly expenses for groceries, car or travel, house rent, utility bills, phone bills, tuition, student loan repayment or insurance premiums that you can’t forgo. Your cable connection is not an essential, your weekly retail therapy is not an essential. You’re grown up – do what’s right! Whatever you’ve decided as comfortable – stick to it. Make it your goal to reach that target and once you have, you’ll feel more confident about life in general!
How do you start an emergency fund?
That’s simple! Start small. Yep, just start – even if it’s a small amount. Keep a separate savings account just for your emergency fund. A high interest paying one is good, but in some cases, there maybe a minimum threshold for such accounts. So the best way to go about this is – just start it (even if its small)! Keep saving (topping up this account) till you reach your target. [Tip: The Habit of Financial Automation]
In my case, once I had enough money in my savings account for the emergency fund, I set up 12 separate fixed (term) deposits for auto-renewal each year – this ensured that 1) I’m forced to think twice before breaking the deposit, 2) I get a good interest rate for idle funds and 3) I don’t need to think about it at all. Shut it and forget it (thanks Hero Honda).
Now that’s getting your money to work for you! (Some people are not comfortable keeping a large portion of cash in low interest savings account. They shouldn’t be. But in India, when an account is giving you 8.5% interest per annum and inflation is at 6% – you really can’t complain. Another idea would be to buy and hold some gold – that’s a true currency that doesn’t lose value!) I’m sure you’ve heard of J.P.Morgan! He once advised a young broker:
“Take waste out of your spending; you’ll drive the haste out of your life.”
What should you do if you’re in debt, do you start an emergency fund?
If you do a search, you’ll find out financial authors like Suze Orman doing a flip and suggesting you just pay your minimum due on the credit card and contribute to your savings fund.
I’m dead against debt… and I’ll recommend her old advice, hers and others, like Dave Ramsey – become debt free – FIRST (though he recommends start with a $1,000 emergency fund and then eliminate debt)! So here’s what you should do with your surplus money 1) Become debt free 2) Setup your emergency fund 3) Start investing. These are what I call the keys to becoming financially independent.
But I have a credit line / over draft / insurance!
Yes, so do I… but I ask a) can you withdraw without being charged? b) are you earning anything on the insurance premium (isn’t that a cash outflow?).
What does it feel like to have an emergency fund?
It feels good! Real good…