Friday, July 30, 2010
How and Why to Start an Emergency Fund
Most personal finance books agree: the first thing you should do — after meeting basic needs, and while reducing spending — is to start an emergency fund.
What is an emergency fund?
An emergency fund is an easily accessible stash of money for use only in case of emergency. It is not to be used to buy a new car. It is not to be used to buy a new Playstation. It is not to be used to remodel your bathroom. It is for use only in case of emergency.
Why do you need an emergency fund?
Do you really need to ask? Here are some simple real-life emergencies:
* I have lost my job. (need time to find job)
* I was just being robbed .
* My uncle had died last week, i need to donate money.
* My handphone just spoilt, need to buy a new handphone.
* Share Market drops dramatically, i have to hold it.
In each case, those people with an emergency fund are going to be in better shape than those without one. Studies show that those without emergency savings are more likely to accumulate debt. It may feel like you can’t afford to have one, but the truth is you can’t afford not to have one. Emergency funds are essential, even for college students.
How much is enough?
How much do you really need? As usual, I recommend that you do what works for you. There is no one right answer. For me, my advice is around 6 months of your expenses.
How do you get started?
Before you begin, be sure that you’re meeting your basic living expenses. And as you build your emergency fund, be sure you’re also reducing your spending and avoiding debt.
I think it’s wise to keep your emergency money someplace that’s not too easy to access. (Ignore this piece of advice if you know you’re disciplined enough not to use the money for other purposes.) You might, for example, open an account at a bank across town. Or deposit the money with an internet bank. Don’t carry a card tied to the account. You’ll still have access to the cash when you need it, but you will be forced to consider your actions before making a withdrawal.
Where to save?
Most probably low risk saving tools.
1. Bank Account
2. Fix Deposit
3. Bond Fund
Starting an emergency fund can be as simple as depositing RM200 per month into your savings account. (At least got a kick start for you)
What do the experts say?
I checked the personal finance books on my shelves to find out what the experts had to say.
Robert Pagliarini, in his forthcoming The Six-Day Financial Makeover, declares that an emergency fund is the most important financial step after taking care of basic living expenses. “Your emergency reserve is your financial cushion in case something goes wrong and you lose your job or you need access to money quickly. Your emergency reserve should consist of at least three months’ worth of cash. Once you’ve saved enough for the cushion, you can [move on] to other goals.”
The Wall Street Journal’s Complete Personal Finance Guidebook says: “How much is enough? The answer is different for different people in different situations. For those in careers with a large, ongoing demand or who have relatively strong job security, three months’ worth of expenses is probably enough of a cushion. Those with bigger career demands, such as higher-paid managers and executives or couples who work in the same industry or at the same company, might want nine months to a year’s worth of expenses in the bank. Yes, that’s a lot of money to save, but financial security is a game won by the most prepared to outlast the tough times.” Use a money market account for your emergency fund, the book recommends, but keep several hundred dollars in cash someplace safe in your home.
In You Don’t Have to Be Rich, Jean Chatzky recommends three to six months of living expenses. Your Money or Your Life recommends six months of living expenses, but only once you’ve achieved financial independence.
In The Automatic Millionaire, David Bach recommends the following three steps:
1. Decide how big a cushion you need. Bach recommends three months of living expenses, though he believes more is better.
2. Don’t touch it. “The reason most people don’t have any emergency money in the bank is that they have what they think is an emergency every month…A real emergency is something that threatens your survival, not just your desire to be comfortable.”
3. Put it in the right place. “Not earning interest on your emergency money is almost as bad as burying it in your backyard.”
I like the approach espoused in Dave Ramsey’s The Total Money Makeover. Ramsey’s very first step is to save $1000 in an emergency fund. Then he advocates eliminating debt via the snowball method. Only once your debt has been eliminated does he recommend building a three- to six-month cushion. This is excellent advice.
Get Rich Slowly