An emergency fund is the first step to wealth. It is difficult and can be impossible to achieve any measure of wealth without the financial and mental ability to shrug off unplanned expenses and minor emergencies.
An emergency fund is a lump of money set aside for unplanned expenses. If you were to have an unplanned expense or minor emergency you would not need to borrow or sell something to be able to pay for it. In a 2013 study by the US Fed 47% of people said that they would have to borrow or sell something to cover an unplanned expense of $400. Building even a small emergency fund can massively lower your stress by removing this instability from your life.
The likelihood of certain risks and the cost that come with them are quite personal, but it is best to think about what are the most likely unplanned expenses to occur for you and then to put a cost on them.
Example of how someone would set their emergency fund:
Broken washing machine – replacement €320
Emergency car repair - €500
Lose your job – 2 months expenses while getting a new job €2,600
In this case, someone with a high risk tolerance might say ‘I believe I can get a job in 2 months so I need an emergency fund of €2,600’, whereas someone with a low risk tolerance might still want 6 months expenses in their emergency fund to feel comfortable.
When trying to figure out what emergency fund you need it can be helpful to think about the most likely unplanned issues you could have. If you have a job that is not fully stable it might be job loss or gap. If you have a car, it might breakdown. If you have children, they might get sick and need doctor visits and medicine. If you own a home, appliances can break. If you are self-employed or work on commission, you might have a few slow months and lower take home pay.
By writing down a list of the main risks you have and the financial impact they would have, you get a picture of what level of funds you need to stave of financial insecurity.
A safe rule of thumb is to have 6 months expenses in an emergency fund.
When you are starting to get your finances in order the idea of 6 months expenses in savings can be intimidating. If you find this the case, start simple and work your way up. Set targets and try to hit them until you get there.
A great point about planning to get 6 months savings in an emergency fund is that is underlines the importance of expenses. The more you can lower your expenses, the less you need in your emergency fund.
An emergency fund also acts as FU (Forget You, or cruder variants) money. Having this FU money allows you to not compromise your values in a work environment. If you are being asked to do something unethical or against your interests or beliefs, you can refuse knowing you have money in the bank.
An emergency fund gives you the basis for developing wealth as you can make investments and long-term choices without worrying about smaller unplanned expenses that can ruin the well laid plans of others.
If you don’t already have an emergency fund, work out what are your most likely unplanned expenses and figure out what you need to comfortably get through them.
If you already have and emergency fund in place, make sure to review it every 6 months to see if it still matches your current risk profile.
Financial literacy leads to reduced stress, better decision making and the ability to plan to meet your personal goals.
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