One of the most essential parts of personal finance planning is to be prepared for any eventuality. It means to be prepared for all emergency situations, no matter what. It does not matter if the economy is devastated by the current Covid-19 pandemic, or whether you are facing a job loss. It does not mean much whether there is a medical emergency or whether your business is going on a loss. Do you know why these won’t matter you or trouble you? Because you would have prepared for them over time? Your emergency funds shall carry you through any problems whatsoever.
The rule of thumb is to have an emergency fund worth 6 months of savings. This means you can go through 6 months without needing funds from anywhere else. Remember, anything can happen during this time: medical emergency, job loss, loss in business, and more. That’s why it pays to be ready for such circumstances. You should save 6 month’s worth of basic living expenses at the very least. With such a fund, you won’t have to use credit cards to cover sudden expenses.
However, there are many emergency fund myths that need to be debunked. In this article, we are going to debunk them one by one.
Here’s the truth: your emergency fund is for one separate purpose and your investments are for a separate reason. Don’t mix up the two. Here’s the difference between the two.
Your emergency fund should be your last resort in case of any unexpected circumstance. Whether it is a financial emergency or a sudden job loss, this is the one you should be using. As such, this should be easy to access and should not be for investing purposes. The funds in your investments are for the long term. These are not to be withdrawn during emergencies unless you really need these of course.
So, these are for the long term and give you higher returns over time. If you withdraw from your investments, you lose income growth by that much amount. It does not matter if you withdraw Rs. 100 or Rs. 1000, you lose if you withdraw. There can be penalties to be paid as well if you are withdrawing from a retirement account.
If you look at your recent history, you can see what the risk is if you use your investment accounts in place of your emergency funds.
The truth is that you’ll lose some serious net worth growth potential if all you do is put money in your emergency fund.
As of now, saving accounts interest rates is close to 0%. The national average APR just for a normal savings account is 0.5%. High-yield savings accounts money markets are giving interests between 0.75% and 1%. Pretty scary, huh?
You can grow your net worth considerably still if you put a part of your money in an investment account. These give 7% on an average in returns per year!
Look, it is not of much use to have too much cash in a low-rate environment, or to put a lot of your month in an emergency fund. You just need to be efficient and keep adequate money in the right account types.
The truth is that you need to save 3 to 6 months of basic expenses. It is not much use of having an unnecessarily huge emergency fund.
To find out how much you should have in your emergency fund, find out what your core expenses are. This represents the amount you absolutely need to have without going down a debt spiral. There is no need to add discretionary spending here.
At the end of the day, you get great peace of mind to know that you have an emergency fund to act as a cushion in rough times.