By Randell Tiongson
QUESTION: Why do I need an emergency fund and how do I go about having one?—Asked by Arnaldo via Facebook
Answer: The reason why you need an emergency fund is plain and simple—emergencies happen.
This fact remains unchanged, emergencies happen whether we like it or not. An emergency can be minuscule or it can be catastrophic. While we can handle small emergencies like changing the batteries of your car, replacing a home appliance or dealing with a minor injury, some emergencies can be stressful. A major health breakdown, loss of employment and business failure are some of the major emergencies that we should prepare for.
It is foolish to think that we will go through life without dealing with an emergency. And most of the time, emergencies cost a lot of money. Thus, the third step in achieving financial peace is setting up your emergency fund.
Before starting an emergency fund, it is best to know how much you actually spend in a month. Many people I know are clueless as to how much they spend monthly. During one financial planning session, I asked someone how much he spends monthly. He told me that he wasn’t sure about the exact figure so he said he would just give me a ballpark figure. The figure he gave me was P40,000 to P80,000. If the discrepancy was about P5,000 to P10,000, it would have been understandable, but P40,000? I politely asked the person to really think about all his expenses, examine his bills, record his spending and get back to me.
If you already have a monthly figure, you are now ready to start building your emergency fund.
The rule of thumb is that your emergency fund should be equivalent to three to six months’ worth of expenses—three months is good, four months is better, five months is great and six months is excellent. Emergency funds come in handy for a variety of reasons: medical emergencies, loss of employment, car breaking down, appliances needing sudden replacement.
But the most common reason for establishing your emergency fund is to prepare for a sudden loss of income.
If you are an employee, there is no such thing as employment security anymore. Job security is actually a thing of the past. Gainful employment can suddenly cease owing to the volatile nature of business and the economy. I have given enough seminars to retrenched employees to know that losing a job, despite your stellar performance, is now a common occurrence.
Markets and the economy go through radical changes and it is unfortunate that companies often see the need to downsize just to remain profitable. Business owners face an even bigger risk of loss of income. Business ventures are speculative in nature, therefore, business failures do happen.
I often advise entrepreneurs to set aside money for emergency funds just in case the business fails or when the business suffers temporary setbacks. Regardless of the nature of your employment or profession, an emergency fund is truly a prudent thing that we should all establish.
Having an adequate emergency fund is a must for everybody. I’ve written on emergency funds in the past and it is a whole chapter in my book, No Nonsense Personal Finance: A Step by Step Guide.
For the readers who already have emergency funds or are building one, congratulations! You are on your way to achieving real financial peace. Here are some more tips for you:
1) Don’t invest your emergency funds. Yes, you read it right! Keep your emergency fund in cash or near-cash placements like savings, current or time deposits. Do not invest your emergency funds as these are intended to be a buffer and will likely be used immediately. Make sure that the deposits can be withdrawn quickly and without huge penalties.
Investing in volatile instruments like mutual funds or Unit Investment Trust Funds, even the less volatile ones like Bond Funds, may not be wise as these are normally sensitive to market changes, and you might experience some losses if you keep your money in the short term.
2) Keep some of those emergency funds in cash, maybe enough to cover expenses for one to two weeks, as you may have difficulty in accessing your bank in sudden emergencies. During calamities, ATM machines may not work, so you would want to have access to some cash.
Just remind yourself that the cash allocated for emergencies should not be touched unless it’s really an emergency, otherwise you will deplete those funds faster than you should. Keep a portion of your emergency fund in an ATM account. Emergencies do not necessarily occur during banking hours and you may need more cash.
3) While I don’t recommend that you invest your emergency funds, it might be a good idea to put them in some placements that will give you better yields than savings accounts. Time Deposits and other money market accounts are ideal instruments where you can park your emergency funds and still realize some minimal earnings.
4) Keep your emergency funds to a maximum of six months’ worth of expenses and then invest the rest.
5) If you are comfortable with managing multiple accounts, having a separate savings account for your emergency funds is a good idea and one I recommend.
“A prudent person foresees danger and takes precautions. The simpleton goes blindly on and suffers the consequences.”—Proverbs 27:12, NLT
Randell Tiongson is a registered financial planner of RFP Philippines. He is a speaker, trainer, columnist and author on personal finance. Attend the 45th RFP program on Feb. 21-April 11. For inquiries please e-mail info@rfp.ph or text <name><e-mail><RFPinfo> at 0917-3464126.