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How to Build an Emergency Fund

Posted on 2020-06-24 08:00:00

Before you even start investing, there are two things you should do first.

Before you even start investing, there are two things you should do first. First, pay off any high-interest debt, such as your credit card and personal loans. Second, save up for emergencies.

Here we’ll focus on the second part; establishing and managing an emergency fund. An emergency fund acts as the first line of defence in a short-term emergency, whether it’s your car breaking down, an unexpected medical bill, or a temporary loss of income.

Before we get into calculating how much you need for your emergency fund, how to save for it, and where to keep it, there’s one thing you need to remember: This money is meant to be used. You’re giving yourself a gift to be able to face what life throws at you. So don’t feel bad about dipping into the fund when you need to pay off an emergency.

Your emergency fund should cover at least 6 months’ worth of expenses
To determine how much money should be in your emergency fund, calculate your fixed monthly contributions, such as your mortgage repayment, car instalment and your monthly savings. It’s important that you include your monthly savings in your fixed monthly contribution. Even if you were to lose your entire monthly income, your savings goals shouldn’t be compromised-- they’re there to make sure you reach your long-term life goals. Don’t let an emergency get in the way of that.

Then, calculate how much you spend every month on things that you can’t go without, such as food. You should only include expenses that are necessary to sustain your living situation, which means cutting out all the nice-to-haves such as going out to dinner and shopping expenses.

Now that you know how much you spend every month, multiply that amount by 6 months to come up with your emergency fund target amount.

Building an emergency fund
The next question you need to ask yourself is: “Do I have this amount already in my savings account?” If the answer is “yes”, can you afford not to touch it unless you have a real emergency? Yes? Skip to the next section. If the answer is "no", you need to make a savings plan to get there.

A structured monthly savings plan is the simplest way to keep yourself on track to save up the difference. Look at your monthly expenses and calculate how much you can afford to set aside each month. From there, estimate how long it will take you to build your emergency fund with that monthly savings amount.

Let’s say you need RM36,000 for an emergency fund, and you already have RM10,000 saved up. This means you need to top-up RM26,000 for your emergency fund. If you can save RM750 per month, it will take you RM26,000/RM750 = 34 months to build your emergency fund. That’s a long time!

To build your emergency fund in fewer months, you’ll need to save more each month, which means you might need to reassess your monthly spending and adjust your budget. For instance, can you cut back on going out for dinners a few more nights a month?

If you’re committed to building an emergency fund within a specific timeframe, calculate how much you need to save each month in that period of time like this:

If you can’t put aside larger amounts each month due to income and expense constraints, consider whether you can make broader lifestyle changes. Should you be paying less on car instalments so you can put more money towards your future? Ask yourself if you’re willing to live less extravagantly so you can achieve your future goals. These lifestyle adjustments will allow you to build your emergency fund more quickly.

And, that extra savings capacity will pay off beyond building your emergency fund: once you have your emergency fund, you can start putting that monthly savings amount towards other goals, such as retiring earlier, or buying a home.

Where to keep the emergency fund
With an emergency fund, you need liquidity. Keep your emergency fund in a savings account, or a low-risk liquid account that earns interest. Don’t keep it as cash because your money loses value to inflation over time if it doesn’t earn any interest at all.

What happens when you use your emergency fund?
When you have to dip into your emergency fund to pay for a car repair or an unexpected medical bill, make sure to top your emergency fund back up again. To do that, you can put your other investing and savings plans on hold temporarily. If this means waiting for another 6 months to buy a home, then so be it: the well-being of you and your loved ones in the short-term comes first.

Is insurance an emergency fund?
Insurance policies are a hedge, not an emergency fund. Insurance policies cover some of the high-ticket emergencies but it doesn’t substitute the cash you’d need for short-term emergencies. Claims on insurance also take time to process and you’ll often need cash before you’re reimbursed. In short, even with insurance, you need an emergency fund.

Do you have an emergency fund yet?
Build your emergency fund as soon as possible because you’ll never know when you’ll need cash unexpectedly. Remember to also build your emergency fund before investing in any of your other financial goals. Although saving to buy your first home sounds more exciting than building an emergency fund, it’s best to protect yourself and your loved ones with a safety net as soon as possible.

Photo by Precondo CA on Unsplash

By The StashAway Content Team


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