Why you need an emergency fund

Posted by FrugalPinoy on Feb 22, 2008 in Financial Tips, Saving | 13 comments

What is an emergency fund?

It’s basically a collection of money that you can access whenever there’s an emergency. And only an emergency. Emergencies may include the following: the sudden loss of a job, unforseen medical bills, a natural calamity, sudden home or vehicle repairs, etc.

Upgrading your cellphone is not an emergency. Neither is buying new clothes – unless your house happened to burn down and all your clothes went down with it.

In the past, I’ve used my emergency fund for medical bills, both for myself or relatives. However, because I was hospitalized last year (for amoebiasis), and had other unexpected medical expenses (I don’t even want to talk about those) my emergency fund suffered a big dent. I need to build it up again.

Where should you put the emergency fund?

Not under your mattress, that’s for sure. Here are some options:

• Savings account with ATM access. Because emergencies seldom happen during banking hours. In terms of accessibility, this is a good choice. However, this may be difficult for those who spend money impulsively. Having your emergency fund accessible might tempt you into using it for unnecessary purchases, and before you know it, it’s almost completely depleted.
• Savings account with only passbook access. Since passbook withdrawals are a bigger hassle, some people prefer this so they won’t be tempted to use the funds. Part of my emergency fund is in this kind of account.
• Time deposit. These tend to have better interest rates than savings account. The downside is that if you don’t have access to it until the maturity date – unless you want to give back part of the interest you earned to the bank. Most of my emergency funds are here.
• Investments. This may include money market funds, mutual funds, and other investments. The return of these investments tend to be high, but you need to educate yourself a lot to get your investments right. Since most of these investments aren’t insured by the PDIC or BSP, if you invest in the wrong areas you might not get all of your principal investment back. This is only good for people with high-risk tolerance and who already have at least 3 months worth of living expenses stashed away (anything above the 3 months you can invest in without feeling unsafe). Personally, I’m still trying to educate myself with investing, so I haven’t taken this route yet.

Also, keep in mind that a credit card is NOT an emergency fund. Using a credit card to pay for huge emergency expenses might cost more in the long run because of the interest and extra fees you need to pay.
There may be other ideas that I haven’t mentioned above. The point is that you should know your risk tolerance and temptation to spend when deciding where to put your emergency fund.

How much should be in the emergency fund?

That all depends on your feeling of financial security and what your monthly living expenses are.

If you work in a high-demand field and you know that it’s almost impossible for you to be unemployed for too long (because of experience, skills, or connections) or you have multiple income streams, then perhaps 3 months worth of living expenses should be enough.

If you’re the sole wage-earner in the household and you have many dependents, or if you have non-regular work (such as a freelance illustrator, independent filmmaker, etc.) it’s good to set aside at least 6 months to 1 year’s worth of living expenses.

How am I doing with my own emergency fund?

My personal goal is to save at least 1 year’s worth of living expenses. This is because I have many dependents and still have to pay for my school expenses. I’m 1/3 through that goal.

My main problem was the medical expenses I spent last year – they really ate away my emergency fund. I still feel safe with the amount left, but I’d feel better and I can take more financial risks (such as investments, riskier business decisions, etc.) if I know that I have a year’s worth of living expenses stashed away.

Do you have an emergency fund? Where do you keep it? How many months of living expenses do you keep stashed away?