Hello everyone! Welcome back to my blog! We’re going to be talking about an ominous sounding concept but honestly it’s the sweetest and most protective concept in personal finance. The Emergency Fund.
Emergency Fund, as a concept, it’s fairly simple to understand. Its a large chunk of money that you do not touch unless confronted with an emergency. There are so many different takes on how much should your emergency fund have. There’s Dave Ramsey suggests $1000 in a glass picture frame only to be broken in case of an emergency (sounds extremely cool!). Some other experts suggest 3-6 months of expenses in a high interest savings account and still others suggest 9-12 months in a high interest savings account or fixed deposit.
The real value of emergency funds is best highlighted in the context of the current pandemic where there were sizeable job losses and pay cuts galore. While neither of these experiences is ever easy, the cushion of an emergency fund takes away some of the stress, while you look for ways to get back on track. And it’s always helpful to have this cushion, pandemic or not.
Naturally, this is a confusing decision to make and can feel very overwhelming. It can also feel like a Herculean task when someone suggests you keep a year of expenses stashed away somewhere. Especially when your expenses are too high as a percentage of your incomes. Not to mention that some of us have erratic incomes because we’re self employed. We’ll look at the problem from both perspectives and also talk about some of the other key points.
When should you build your emergency fund?
They say that your emergency fund should be the first thing you build in your pursuit towards financial health. Absolutely, 100% true. One simply cannot move without the space and freedom of am emergency fund. I can vouch for this, I’ve been paying off my debt without having built off an emergency fund and this month, I really felt the heat of it. My laptop was acting up and I was afraid it would break down. With no money set aside for a replacement and nearly 50% of my income from the past three months having gone in debt repayment I was truely petrified! I was afraid that I would have to resort to credit cards again. Luckily, the laptop overlords blessed me and my laptop is fine for now.
This experience has prompted me to take a shift in my debt repayment approach. My target for my soon to arrive pay-check is an equal balance of debt repayment and emergency fund building. Luckily, mine being consumer debt is shorter term in nature. For longer term loans, it becomes even more imperative to build an emergency fund before or along with the debt repayment process. You need to have some money on the side that you can reach out to. You never know when you’re going to need it. Once you’ve built that amount, you can by all means go on and make larger repayments on your debt.
Even if you pay more in interest by waiting and building the emergency fund, my sincere advice would be to do so. However, if your debt is really weighing you down, then I would suggest an aggressive approach but still finding a way to put atleast 10% on the side to build an emergency fund, so that if nothing else you have some minimum payments set aside should your income go south.
This is equally important for both people with fixed incomes as well as freelancers. If the pandemic has taught us anything, it’s that no one is truly safe or unscathed and that cushion is critical for everyone, irrespective of the nature of your income.
Conclusion: Build your emergency fund first. Or at least simultaneously. And it doesn’t matter who you are. You need it!
Emergency Funds or Investments? Which first?
Emergency fund first. Infact, putting your emergency fund in a fixed deposit or high interest savings account can be your first step towards investing. Granted its not as glamourous as investing in stocks, but real life practical investing rarely is. You can also use a recurring account as means to build your emergency fund. This way you earn some interest while building the fund and reach your goal faster, which again is investing. Maybe you’ll not be the Wolf of Wall Street when doing this, but this is what you need to do first before starting on the investing journey.
Trying to build your Emergency Fund by investing in equity funds or such SIPs can be counterproductive, particularly when faced with volatility. Don’t use investing as a means for saving for your emergency fund. Save the fund first, the old fashioned way and then knock your investments out!
Conclusion: Always build the Emergency Fund first.
Building an emergency fund
Budgeting and assessing the quantum of your emergency fund, go hand in hand. Your bugdet will help you arrive at your expenses. This number is multiplied by the number of months of expenses you want to have saved is your emergency fund.
For instance, my monthly expenses are Rs. 100 and I want to have an emergency fund of 12 months stashed away, that makes my emergency fund requirement Rs. 1200. Very simple calculation.
Conclusions: Know your expenses to know your emergency fund.
How do you decide the size?
This is truthfully the trickiest question in the process. Experts recommended anywhere between 3-12 months of expenses. Your personal risk apetite and priorities are the biggest decision points for this.
- Your risk apetite: Many suggest that freelancers, have a larger emergency fund as opposed to those with a salary because of the variability and voltality in their incomes. However, once again to put the pandemic as a perspective, people have lost jobs that they have been at for years. So truthfully, it is your personal risk apetite that needs to be your compass. This also ties in well with your priorities.
- Your priorities and plans: Maybe you can stomach having a 3 month emergency fund and you want to begin investing to reap that sweet, sweet compound effect. In that case, by all means save three months of expenses and move forward. But say you want to quit your jobs and explore a business or a creative pursuit which will earn you money in the long run, but say in the short run you would be hustling to set up. In that case maybe 12-15 months of expenses would be more suited to you!
Bonus Tip: Emergency Fund and Runway
One of my favourite YouTubers is Matt D’Avella who in a video of his talks about having two back ups, an emergency fund worth a $1000 and a runway goal which at its peak, is a year of expenses saved. This in my opinion, is the ideal situation. Your runway becomes an excellent. much larger amount to fall back on, without you ever having to touch your emergency fund for a year. This is particularly useful for freelancers who have a dependence on equipment. That emergency fund becomes your way of replacing equipment on an urgent basis, without worrying about how you’ll pay rent next month or even six months after.
I would personally want to first build an emergency fund which would be about three months of my expenses. My intention is to stash this emergency fund and then proceed to build a runway fund of about 12 months of expenses while pursuing investments. It’s important to note that I intend to build the emergency fund over a period of 4-6 months and the runway fund over a period of 1-2 years. These are short term goals for me. I would like to have both funds as a back up since I don’t have the biggest risk appetite.
I want to store my emergency fund in a fixed deposit so that it’s easily accessible to me and the rate of interest keeps pace with inflation. My runway would probably either be in a fixed deposit or a liquid fund depending upon the market situation when it’s accumulated.
Conclusion: Decide the size of your emergency fund keeping in mind the expert view but tailoring it to suit your risk appetite and priorities.
How do you save for an emergency fund?
The next most important step is actually getting down to saving for the emergency fund. This seems like a real herculean task since you never feel like you can possibly save up for it. Either your income is unstable or your cost of living too high or maybe you have debt. There just never seems to be enough money in our pay checks. However, given that we’ve already established its importance we now know that this is non negotiable. So let’s look at a few ways that we can achieve this.
- Percentage based: This involves you deciding a fixed percentage contribution for each month from your pay-check. For instance, I’m going to be starting with a 15% contribution from my pay-check for this month. This percentage is for you to decide and tailor depending on how much you can afford. I would sincerely recommend cutting back as much as possible on discretionary expenses during this phase so that you can max out the amount and reach your emergency fund faster. For freelancers, you need to assess the size of every pay-check and decide your percentages. So when larger pay-checks come in, increase the contribution to the emergency fund so that you’re not stressed out in the months with lower income. This money should immediately go into either another bank account that you don’t use or a recurring account so that you can’t touch it. Treat it like it never came into your life!
- Financial challege: This is honestly a fun way to save and it’s especially accomadating for those with fluctuating incomes or beginners in savings. The basic principle is that over a course of 52 weeks, you save money by starting with a small sum and multiplying it each week with the number of the week you are in. Say you want to save in multiples of Rs. 100. So in your first week, you put away Rs. 100 into another bank account or recurring accounts, Rs. 200 in your second week and so on until in your 52nd week you put away Rs. 5200. Your amount at the end of the year would be Rs. 1,37,800. All by a starting sum of Rs. 100. Now, the reason that I say this is probably a good way to save for freelancers is because you can choose your multiples based on the pay-checks you get in the month. So in the weeks where you have more money you can siphon off maybe the higher numbers (say the 40-52 week numbers) and in the weeks when you’re tight on cash on you save the lower week numbers (say the 1-10 week numbers). That way your savings mindset isn’t hampered. Some people like to challenge themselves by writing the numbers 1-52 in chits, putting them in a jar and picking up a chit randomly each week. So you could end up with chit number 52 and have to siphon off 5200 on Day 1! You can choose your way to implement this. A lot of people recommend this to establish travel or other sinking funds, but I think this is an effective way albeit longer way to save up an emergency funds.
- Using windfalls like performance bonues: If you are absolutely sure about receiving some windfalls in a year like performance bonuses, joining bonuses, inheritances etc. you can divert those towards your emergency fund when they arrive. These can be very helpful to gain a headstart or a jump on things since you’re saving in bulk.
Conclusion: Find your preferred way to save for an emergency fund and maybe, make it fun and interesting!
Where do you put it?
You need to put in an emergency fund somewhere, where it is easily accessible to you, when you need it. An added bonus would be if that money can work for you to earn some interest so that at least it keeps pace with inflation and you’ve earned something. You can put it in a high interest savings account or a fixed deposit if you want to earn a fixed rate of return. If you’re slightly more adventurous then maybe a liquid fund which may earn you a little more than a fixed deposit, but bear in mind that it may fluctuate a bit.
Conclusion: Stash your emergency fund somewhere out of your direct sight and that earns you some additional money.
Most important lesson
I cannot stress this enough: This wont happen overnight.
Your emergency fund will require not just money but also your patience in it. You have to keep at it and consistently build the money in it to reach your goal. And if like me you intend to build both an emergency fund and a runway fund then you need a lot more patience and time.
You also need to cut yourself some slack. Maybe some months when you’re trying to reach the goal something happens and you have to spend it on emergencies like medical bills or car repairs or equipment replacements. That’s fine because those emergencies are what that money is for. But please don’t spend it on something tht’s not technically an emergency like maybe a new phone if your current phone is perfectly fine and you just want the upgrade for fun.
Emergency funds are an important step to financial liberation. When you have enough wiggle room to pursue something in the short term, without having to worry about a roof and food, you’re truly on the way to freesom. Having this actually builds your risk apetite because you have something to fall back on.
I hope you enjoyed the post. Do let me know your thoughts on the whole concept and your experiences with building one! See you on the next one!