Emergency Fund is one of the most discussed, and often very confusing topic for a lot in personal finance. Not only do some people not have one, those who do often fail to understand its basic premise and how to best use it.
First, let us try and define what an emergency fund is in a way that most can understand and agree on. In its simplest terms, an emergency fund is money you set aside for the absolute specific purpose of covering unexpected expenses or financial emergencies, thus negating the need to rely on borrowing or credit cards. Talk about taking the ‘fun’ out of ‘fund’! Too bad if you thought an emergency fund can be dipped into for fun activities. More on that later.
Envision a scenario where your vehicle unexpectedly malfunctions, necessitating expensive maintenance that exceeds your financial plan. Rather than worrying about the expenses or accruing debt, your emergency savings can effortlessly handle the repair bills. This reserve serves as your economic buffer, offering prompt financial resources during unforeseen events, thus preserving your financial status instead of ruining it.
Now that we agree on what an emergency fund is, let us go through some misconceptions about them, This is a critical part of financial planning, and a lot of people are not sure about its purpose and management. Here are some common misconceptions:
- Not Necessary if You Have Access to Credit: Some people believe that having access to credit, such as credit cards or lines of credit, negates the need for an emergency fund. However, relying solely on credit during emergencies can lead to debt accumulation and interest charges, which can eventually snowball into financial stress. Unless absolutely needed and don’t have an emergency fund in place, don’t even think about using credit to cover an emergency
- Only Needed for Unemployment: While job loss is a significant reason to have an emergency fund, it’s not the only scenario where it’s needed. Car repairs, unexpected medical expenses, home maintenance issues, an unforeseen big bill can also require immediate access to funds.
- One-Size-Fits-All Amount: It’s a common misunderstanding that a universal sum should be allocated to everyone’s emergency fund. However, the truth is that the ideal amount for such a fund is subjective and fluctuates based on personal factors, including one’s earnings, outgoings, and the number of dependents. And no two individuals or families are the same. A family with one kid and modest expenses may only need $3K in emergency savings while a family that has a large home, multiple cars, a cottage home and a boat may require a lot more. You need to sit down and assess your monthly expenses and then multiple that by at least 3.
- Should be actively invested rather than left idle: While some suggest high-risk investments for potential growth, it’s crucial to maintain these funds in liquid and low-risk accounts like savings or short-term redeemable GICs. This approach ensures quick access during emergencies, which can happen unexpectedly—fulfilling the primary purpose of an emergency fund.
- Not Needed for Young or Healthy Individuals: Even if you’re young and relatively healthy, nothing is guaranteed and unexpected emergencies can still occur, such as accidents or unforeseen medical costs. Having an emergency fund provides financial security and peace of mind regardless of age or health status. As the famous saying goes “better have it and not need it than to need it and not have it”
- Can Use Other Savings Instead: I was actually guilty of this when I first started my journey with personal finance. It’s common to think that you can tap into other savings, such as retirement accounts or investment portfolios, during emergencies. However, accessing these funds prematurely can result in penalties, taxes, or loss of potential growth. Not to mention, once you break the savings momentum or what took you long to build and accumulate, it may be hard to rebuild it and will take a long time.
- Once Established, No Need to Revisit: People often create an emergency fund and then forget about it. However, life circumstances change over time, and regularly revisiting and adjusting the emergency fund based on current needs and expenses is essential. Make it a habit to revisit and review your emergency fund once every 6 months or even once a year. Did anything change? Do you need to increase or decrease the amount?
Are you guilty of any of those? better yet, are you guilty of the biggest mistake of all, not having an emergency fund at all? The time is now to create one and ensure you are using it properly. Should you ever need it, for a small or big emergency, it will be there to save the day and make the emergency a lot less stressful.