DEFINITION OF ‘EMERGENCY FUND’
An account that is used to set aside funds to be used in an emergency, such as the loss of a job, an illness or a major expense. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to use high interest debt, such as credit cards, as a last resort. That means emergency fund is an account that’s earmarked for spending on urgent, unplanned situations only. It’s intended to be used only for worst-case-scenarios.
“Money magazine states that 78% of us will have a major negative financial event in any given 10-year period.” Now you got the idea.
Emergency fund should cover three to six months of expenses.
If you have a ‘steady,secure” job and your all family members are healthy you prepare for emergency fund of three month expenses. If your job situation is unstable or there are chronic medical problems in the family, you should have emergency fund of six month expenses.
We use emergency fund as three to six months of expenses instead of three to six months of income because the fund is to cover expenses, not replace income. Your income include payment towards retirement fund and other long term goals, during these period you may avoid the payment towards goals.
Emergency funds are highly liquid, such as savings accounts. This allows quick access to funds, which is vital in emergency situations. Emergency fund is not for wealth building, so don’t put it into mutual fund or other investments.
Why Do I Need an Emergency Fund?
Creating an emergency fund is your way of expecting the unexpected. You might be forced to tap your emergency fund if:
- If you become ill
- If you lose job
- A tree falls on your house, damaging your roof
- You get into a car accident and your auto insurance will only cover half the bill.
- A family member becomes sick, and you need to take care of them.
- emergency hospital expenses, and your insurance won’t cover the total bill.
You get the idea.
What Does an Emergency Fund NOT Cover?
Your emergency fund is NOT meant to cover expected occasional costs. Your washing machine will break. Your refrigerator will stop running. Your Air Conditioning not working, Your water heater will need to be replaced. You can plan on these things happening.
Those are expenses you should budget toward. Say your Refrigerator costs Rs.25,000/- and lasts for 8 years, which means that if you save Rs.260 per month in your “Refrigerator replacement” fund, you’ll be prepared eight years from now.
You may want to save double – Rs.520/- a month — so you’ll be ready if that Refrigerator breaks four years down the road.