Learning how to start an emergency fund helps prepare you to overcome unexpected events that could otherwise threaten your financial health.
The COVID-19 pandemic was a powerful reminder there are larger forces in life that remain outside of our control. Without warning, emergencies can and do happen.
However, wise financial planning, of which an emergency fund is a key part, can help you mitigate the negative impacts of these crises.
This is why it’s so important to start building an emergency fund as soon as possible, and why so many people are now following this sage advice.
In the UAE, residents have increasingly started to get on top of their savings. According to a 2019 study from the National Bonds Savings Index, more UAE residents have started saving earlier in life.
In this article, we’ll explain everything you need to know about how to create an emergency fund, including how much money each individual should budget for it.
We’ll also review the function an emergency fund can play within your overall financial plan.
Importantly, we’ll teach you how to start an emergency fund right away, using four easy steps:
- Create your budget
- Determine your emergency fund goals
- Decide on a savings plan
- Choose where to build your emergency fund
But first, let’s learn about what an emergency fund should do — as well as whether it is right for you.
What is an emergency fund?
An emergency fund is money that you set aside for unplanned and unexpected expenses.
According to Vanguard, an emergency fund is “a stash of money set aside to cover the financial surprises life throws your way. These unexpected events can be stressful and costly.”
These emergencies could include:
- Unplanned medical expenses
- Job loss
- Unexpected repairs
- Natural disasters
- An unexpected dip in business performance
- Unexpected travel
Any of these (usually unforeseen) life events could require a substantial outlay of cash outside of your monthly budget.
An emergency fund is designed to meet these unexpected expenses and avoid a possible financial disaster.
It helps to think of an emergency fund as a self-funded insurance policy.
Typically, a good emergency fund is defined if it has these three features:
- It is accessible: An emergency fund should be liquid (easily convertible to cash). It must also be a source that is easy for you to get your hands on.
- It is only designed for emergencies: An emergency fund has a single purpose — to cater for emergencies. You should not use the cash for anything else. Hear it from Suze Orman, a veteran financial advisor, TV personality and founder of the Suze Orman Financial Group: “Never invest emergency savings in the stock market.”
- It is readily replenishable: Once you have exhausted the cash on an emergency, you need to replenish it in preparation for another emergency. Emergencies are by nature unpredictable, so an effective emergency fund must be maintained.
Do I need an emergency fund?
Who exactly needs an emergency fund?
The simple answer is that everyone who does not have absolute control over how life events impact their financial circumstances should learn how to start an emergency fund.
In truth, even wealthy people should build an emergency fund. This is simply because life is unpredictable:
- Job losses do occur
- Unexpected travel can arise
- Natural disasters happen
- Major medical emergencies are never planned
If you have ever faced any of the above circumstances, it’d be wise to build an emergency fund.
Advantages of an emergency fund
How will an emergency fund benefit your finances? To understand these benefits, you need to compare it with the other (unideal) alternatives for funding emergencies — debt purchasing and personal savings.
Below are three clear advantages of emergency funds:
It prevents the accumulation of debt
In the absence of an emergency fund, you may need to borrow money from a bank or credit union to cover emergency expenses.
What’s the problem with that? High interest rates.
When you borrow money from a bank or credit union, you will pay back with interest (which can be high, depending on the circumstances). Nathan Morris, author of The Art of Getting Money, is right when he says, “every time you borrow money, you’re robbing your future self.”
An emergency fund provides you with an alternative (and better) solution. You can solve your emergencies with your money – no interest, no accumulated debt, no threatened relationships.
It protects your investments
An emergency fund is an essential part of a long-term investment strategy.
Without an emergency fund, you may be tempted to liquidate your investments (sell your stocks, bonds, mutual funds, or ETFs) to cater to emergencies.
The disadvantage is that you might be selling when the market is low and receive cheap prices for your stocks. The market might then go on an upward trend after the emergency, meaning that you might have to buy the stocks back at a higher cost, which reduces your potential returns.
Buying and selling stocks regularly could also increase the fees and commissions you pay further reducing those returns.
To protect your investments, you must avoid liquidating them because of emergencies.
If you are a passive investor (as long-term investors are advised to be), it is even more critical that you avoid liquidating your investments. Building wealth requires you to invest for the long term — not become a hostage to the whim of sudden, short-term events.
Here is one of our favorite Warren Buffet quotes on this issue: “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
True wealth accumulation is a long-term strategy. By starting an emergency fund, you can protect your long-term plan and avoid liquidating any investments because of emergencies.
It helps avoid financial disasters
People without a plan to deal with emergencies are more likely to succumb to financial disasters. And a growing debt profile is only one of the potential pitfalls.
Emergencies also can result in emotional problems – grief, sadness, depression. This occurs when you don’t have a prepared way to deal with crises (or the only available methods are also burdensome).
An emergency fund helps provide you financial stability and confidence to deal with unforeseen events and forestall and/or mitigate financial disasters (and the emotional baggage that accompany them).
How to start an emergency fund: A 4-step process
So, how can you start an emergency fund?
In truth, everyone wants to avoid debts, financial disasters, and the forced liquidation of their investments.
Here, we have outlined four essential steps to help get you on track.
Let’s look at them in turn.
1. Create your budget
Budgeting is the heart and soul of a secure financial life. This is where it all begins.
But why do you need a budget?
Before you can save for an emergency fund, you need to keep a tab on your income and monthly expenses.
“A budget helps to instruct where your money will go, instead of wondering where it went,” says John C. Maxwell, a best selling author and speaker.
Identify Your Income Sources
The first step is to identify all your income sources.
If you are a salary earner, how much is your monthly income? If you operate a small business, what is your average monthly profit? If you are a freelancer, what is your average monthly income?
Your income sources can also include interest and dividends from investments and income from part-time jobs.
Ensure you have a monthly figure for all your income sources. If the money comes in only once a year, you can divide it over twelve months to get a monthly figure.
Identify Your Monthly Expenses
Do the same for your expenses. Identify all your monthly expenses and sum them up. To make it easy, create categories, such as food, restaurants, telecommunications, mortgage, medical insurance, etc.
Next, identify the costs you incur under each category.
For non-recurring expenses (one-off purchases), pro-rate them over the twelve months to get a monthly figure.
To calculate your budget, the 50:30:20 rule is considered best practice; it optimally divides your budget into essential expenses, discretionary spending and savings. Here is how it works:
First, you’ll need to divide your expenses into essential (food, rent, healthcare, mortgage) and non-essential/flexible (shopping, entertainment, travel).
Then you allocate 50% of your income to essential expenses, 30% to non-essential/discretionary expenses, and the remaining 20% to investments, debt payments and savings.
Whatever strategy you use, ensure you have a budget and stick to it.
Remember, for every good budget, your income must exceed your expenses.
2. Determine your emergency fund goals
So what about the remaining 20% from the 50:30:20 rule?
Part of that 20% will go to your emergency fund, with the remaining going into debt financing and investments.
Here, it helps to set up an automated savings program. This will specify a fixed amount to be automatically deposited into a savings or investment account, ensuring that you’re contributing regularly.
The next step is to decide what portion of your savings will go to an emergency fund.
Below are certain factors you should consider.
Factors to consider when determining how to start an emergency fund and plan goals
Some jobs are more secure than others. Some industries have more job security than others.
Yet, no matter the situation, job loss is considered the most likely of possible financial emergencies. Therefore, you need to understand your industry and the job security your current employment provides.
Related to job security is frictional unemployment.
Frictional unemployment is unemployment caused by people moving from one job to another. The level of frictional unemployment in your industry will help you estimate how long you can expect to stay out of a job in the event of a job loss.
If you have people that depend on you, their emergencies are most likely yours, too. You need to consider this when deciding on your emergency fund goals.
If you have a large backlog of debt, you may need a smaller emergency fund compared to someone without debt. Why is that? By delaying your debt repayment to save for an emergency fund, you will be incurring extra interest expenses.
The interest your emergency fund will generate will almost always be lower than the interest on unpaid debt. Therefore, you must channel enough funds for debt repayment, which ends up rationalizing a smaller goal for your emergency fund.
If you are married to a working partner, you may need less cash for emergencies, ceteris paribus.
How many months to plan for: Putting it all together
None of these factors should be considered in isolation when building an emergency fund. Every one interacts with the other to help us get the clearest picture of the financial needs our fund must provide for.
By this time, you should be in an excellent position to determine your emergency fund goals.
While some financial advisors advocate a three-month fund, a six-month emergency fund offers the best protection. However, this largely depends on your personal financial profile, which the above has helped you determine.
To calculate the ideal value of your emergency fund, multiply your monthly essential expenses by six and you will have your fund goals in a concrete number.
For a six-month fund, if your monthly expenses are $2,500, for example, you should save up about $15,000 in emergency funds.
3. Decide on a savings plan
Now you have a target. But how do you achieve that target?
The next step is to decide on a savings plan to best achieve that goal.
Now ask yourself how much of your income do you want to save every month to reach your target.
Following the 50:30:20 rule, you should have 20% of your monthly income for savings, investments, as well as any debt repayments. The big question is how you should allocate the money.
There is no one-size-fits-all answer for savings allocations, as each person has a different lifestyle.
One factor to consider is your debt repayments. If you have a large debt profile, clearing those debts through the debt snowballing system should be a priority.
In that case, you should reduce long-term investment goals and commit more savings to debt servicing and emergency funds.
Delaying your emergency fund (entirely) because of debt repayment is not advisable. If an emergency arises while you are paying off debt, you will only incur more debt. This decision will also depend on all the factors in the last section.
If debt is not in question, you can allocate savings between an emergency fund and a long-term investment plan (10:10 and 15:5 are very good options).
However, don’t commit all of your savings to long-term investments until you have achieved your emergency fund goals.
Once you decide on a savings plan, stick to it and start building your emergency fund.
4. Choose where to build your emergency fund
An essential part of learning how to start an emergency fund is deciding where to put your cash.
Once you kick start your savings plan for an emergency fund, where should the money go?
In the beginning, we outlined the three features of an emergency fund.
- It is accessible
- It is designed for emergencies
- It is readily replenishable
Accessibility is important when deciding where to stash your emergency fund. Liquidity (rather than interest) is the priority.
A more accessible (liquid) account with low interest is better than a less accessible account with higher interest.
However, while liquidity is primary, you can still seek higher interest rates at the same liquidity level.
Below are some options to consider:
- Savings accounts: A savings account with a bank or credit union will offer a considerable interest rate and high liquidity. While some banks will require a minimum balance or charge monthly fees, others won’t. Shop around for high-yield savings accounts without monthly fees or a required minimum balance.
- Money market accounts: Money market accounts are similar to savings accounts. Though they offer higher interest rates, they also have a higher minimum deposit requirement. Shop around for money market accounts with little or no minimum deposit requirement.
- Money market mutual funds: They invest in liquid, near term securities. They are low-risk with high liquidity. They may be a good option for a part of your emergency fund.
What role emergency funds play within your overall financial plan
Emergency funds do not stand alone. While you should understand how to start an emergency fund, you should also know how it relates to your overall financial plan.
Two things are incredibly important to consider here:
Emergency fund and debt
If you have debts where interest accrues on the unpaid balance at the end of the month (e.g., credit cards, student loans), they should take precedence over building an emergency fund.
These types of debts should not be confused with so-called good debts, such as mortgages, which are payments that build up your total net worth and bring in additional returns, including monthly rent.
However, in the case of bad debt, the interest on those unpaid accounts will be higher than the interest you earn on your emergency fund.
Here, we have to carefully balance our debt payments with emergency planning: While you may not completely put your emergency fund on hold, repaying such debts should be a priority.
Emergency fund and long-term investment
An emergency fund is an important part of your long-term investment strategy.
First, it prevents you from liquidating your investments because of emergencies.
Secondly, there is a relationship between emergency funds and the automation of your long-term investments.
If you use the 50:30:20 rule, then, assuming there is no debt, you have to share your monthly savings between emergency funds and long-term investments. Emergency funds thus become an essential determinant in your investing decisions.
You cannot create an investment strategy or successfully automate your investments without thinking about emergency funds.
On the flip side, long-term investments also affect the emergency fund. If you commit too much cash into an emergency fund, the opportunity cost manifests as the missed wealth you could have built in an ETF or passively managed index funds.
Therefore, treat emergency funds as a part of your long-term investment strategy. Not as an isolated plan.
Creating a long-term investment strategy
How do you create a long-term investment strategy that strikes the right balance between protecting (through emergency funds) and growing (long-term investments) your wealth?
Sarwa is a robo advisor that can help you create and execute a long-term investment strategy that matches your financial goals.
Sarwa uses the Modern Portfolio Theory to create automated investment strategies (minimum risk, maximum returns) that grow your wealth over time.
Our accounts automatically rebalance your portfolio and allow you to enjoy the benefits of time-proven investment strategies, such as lump-sum investing and/or dollar-cost averaging.
Emergencies do happen. However, preparing for those emergencies with a sound financial plan can keep you standing strong irrespective of the circumstances.
Sound financial plans must include an emergency fund.
Here are four things you should remember about emergency funds:
- An emergency fund will help prevent debt accumulation, protect your savings, and avoid a financial disaster.
- A six-month emergency fund will offer you greater protection
- Starting an emergency fund begins with good budgeting practices (the 50:30:20 rule, for example)
- Emergency funds play a crucial role in your long-term investment strategy and overall financial plan