What is an Emergency Fund and Why is it Necessary

One important aspect of our educational system that is lacking is the incorporation of personal finance into the curriculum. At the heart of personal finance is budgeting and living below your means, while this will give you better chance of achieving financial freedom there are other steps to take to ensure your path to achieving your goals. Saving money for retirement isn't enough; you also need to plan and find ways to secure your plan to keep it from failing. One method of securing your financial plan is an emergency fund. Creating an emergency fund is an important step in personal finance. Some people skip this step and later regret it when the need arises.

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What is an Emergency Fund and Why do you need it? 

So, what exactly is an emergency fund? And why is it so crucial? An emergency fund is money set aside to cover unexpected expenses or to replace lost income temporarily. Life is full of unexpected events, and it is critical to be prepared for them. 

2020 is a perfect example, A lot of people were caught off guard by how COVID affected them financially. Nobody expected months of lockdowns and months of lost income. Most Filipinos who were already struggling before the pandemic were in desperate need of government assistance. Those who have credit cards resorted to borrow money to cover their basic needs. This resulted in a huge spike of credit cards users who were unable to settle their credit debts after the lock down was lifted.

 

The few who managed to set aside an emergency fund prior to the lockdown got through those trying times better than most people. Although an emergency fund can't get you through all unfortunate events, it can provide you time to allow you to find ways to get through the problem.

How much do you need for an Emergency Fund?

So, how much money should you save for an emergency fund? Most personal finance books and articles recommend setting aside 3-6 months of your household expenses for an emergency fund. I recommend 6 months of expenses as an ideal amount because 3 months would not have sufficed if you were to go through the lockdowns in 2020 and 2021.

How to start building your Emergency Fund?

Now that we've determined how much you should save for an emergency fund, the next big question most people have is, "How can I save that amount when I'm living paycheck to paycheck?" Unless you're unemployed, you can accomplish this feat by setting aside a small portion of your income each payday. The most common personal finance quote is, "Pay yourself first." Paying yourself first means setting aside a portion of your income for your future self before spending it on other expenses. Once you have established an emergency fund, the funds you set aside can be used to build your investments.

 

If money is really tight, you could start by putting aside as little as 5% of your income each payday for an emergency fund and gradually increase it once you've gotten the hang of it. Keep in mind that the less you set aside from your income, the longer it will take you to reach your goal. It would be ideal if you could set aside 20% of your income to help you reach your goal faster. 

How long will it take to complete an Emergency Fund?

If you are frugal with your money and spend far less than your income, you will finish this task much faster. Because the emergency fund is based on your monthly expenses, the smaller your expenses are in comparison to your income, the less of your emergency fund is required.

 

It will take 114 months to build an emergency fund if you only save 5% of your income. It would take 54 months to build your emergency fund if you saved 10% and lived on 90% of your income. If you set aside 20% of your income for an emergency fund and live on the remaining 80%, you'd be able to reach your goal in just 24 months. However, if you normally spend only half of your income and save the other half for your emergency fund, it will only take you six months to finish it.

 

To achieve this goal as soon as possible, you must budget carefully and cut back on your spending. One way to save money is to avoid unnecessary purchases. Dining out, entertainment, gadgets, vices, and expensive clothing are all expenses you can cut.

Final Thoughts

I understand that not everyone can set aside a portion of their income for an emergency fund, especially given that the majority of Filipinos live in poverty. However, if you can spend money on frivolous expenses, there's no reason you can't save for an emergency fund.

 

Establishing an emergency fund is just the first step to accumulating wealth. When an unexpected event occurs, an emergency fund will keep you from making unwise investment decisions. It will keep you from selling your investment prematurely or at a loss just to cover unexpected expenses. This is why it is critical to first establish an emergency fund before beginning to invest.