What is an Emergency Fund and Why Do You Need One?

Recently updated on: September 17, 2023

TL;DR - An emergency fund is a saving worth three to six months of your monthly salary for emergencies, like job loss, medical emergency, or home repairs.

Emergency Fund 101
What Is An Emergency Fund And Why Do You Need One? 5

What if you suddenly lose your job? How long do you think you'll survive without asking for help from your family and friends or before taking a loan?

Some may say a month or two, but for many employees living paycheck-to-paycheck, it's a week or worse since they are already knee-deep in outstanding consumer and lifestyle debt.

Many uncertainties and emergencies can easily bring us to our knees if we’re not financially prepared. It can be a sudden job loss, a medical emergency, a car breakdown, or an immediate housing repair.

This is where an emergency will come in, which will be our topic this week. If you’ll remember, an emergency fund is one of the steps to a strong financial hierarchy, which is crucial for your personal finance.

What is an Emergency Fund?

Person Putting Coin In A Piggy Bank As Emergency Fund
Photo By Maitree Rimthong On Pexels.com

An emergency fund (or a rainy day fund) is a saving, usually worth three to six times your monthly expenses.

But there are situations where you'll need to have more than a year's worth of emergency funds.

This fund should only be used as a safety net for when an unforeseeable event suddenly happens, hence, the 'emergency' in its name.

What is the Emergency Fund Ratio?

Weakness 1
Emergency Fund Ratio Formula

The Emergency Fund Ratio or the Liquidity Ratio measures how liquid your household is during emergencies by dividing your total liquid assets, like your cash on hand and cash in banks, and your total monthly expense.

Based on the formula, your emergency fund ratio must be at least 3, indicating that you can meet at least three months of your expenses.

For example, if your household monthly expense is P20,000, and your total liquid assets are P45,000. Then your emergency fund ratio will be only 2.5, indicating that your emergency fund needs to increase.

Why Should You Save For an Emergency Fund?

The goal of your emergency fund is to serve as a buffer to cover your unexpected expenses that will disrupt your budget and may even force you to fall into debt.

Think of it this way, if you suddenly lose your job, how long do you think you’ll need to find another job to support your family?

Or what if you suddenly need an emergency roof repair in your house just in time before the rainy season arrives?

Or what about if you suddenly get sick and can’t work? How will you support your family during this time?

The idea behind an emergency fund is to add a layer of protection for your family from unforeseen events and give you peace of mind.

Who Should Save For An Emergency Fund?

I remember some people who never saw the importance of an emergency fund because they felt secure with the benefits of their regular jobs. Then the pandemic suddenly happened, and they found themselves out of work.

With no emergency funds saved, they were forced to get into debt, liquidate their investments, and even risk themselves to earn to sustain their everyday needs while looking for another work.

Their problem was that no one could have predicted a global pandemic hitting the country and affecting them directly — and that is why everyone needs an emergency fund.

Begin With A Starter Emergency Fund

To be fair, building a fully funded emergency fund of three to six months’ worth of expenses will take years, which will be overwhelming for many. That’s why we may start with what Dave Ramsey called a “starter emergency fund.”

According to Ramsey, a starter emergency fund is worth $1,000 and is used to cover some emergencies while paying off your debts.

However, if we place this in the Filipino context, the $1,000 will look too much. Instead, I suggest a P10,000 starter emergency fund.

I chose P10,000 because it is not too high that it can intimidate beginners, yet not too low that you’ll skip it. It can also help you gain momentum and confidence in saving because it is a five-digit amount.

What Counts As An Emergency Expense?

Personally, I classify an emergency as a difficult event to predict. This includes job loss, natural calamities like fire, flood, and typhoons, emergency car repairs, sickness, and other unfortunate circumstances.

However, I don’t consider a tuition fee an emergency because it’s predictable that students will enroll every year. More importantly, the new shoes, clothes, or phones you see on sale are never an emergency.

Where Should You Keep Your Emergency Fund?

Your emergency fund should be highly liquid, meaning it should easily be accessible when needed. So you must place part of it in a savings account and some cash stash at home.

It is also best to have a separate bank account for your payroll account to identify funds quickly.

Personally, I have two separate banks holding my emergency fund. So if one bank is offline, there is another option.

After completing your emergency fund, it is also good to place a part of it in a low-risk investment like high-interest savings banks, short-term bonds, or money market funds.

Emergency Fund vs Credit Card

Using your credit card as an emergency fund is a big NO!

Thinking that your credit card is free money that you'll use during emergencies will only put you into debt.

Sometimes, using a credit card is better than cash, but this is not applicable in emergency funds.

Final Thought:

Having an emergency fund is crucial and fundamental to anyone’s financial stability. It can save you from undesired debt and problems when unexpected events happen.

If needed, never hesitate to use it. Let it serve its purpose. Afterward, you can always save replenish it.

Key Takeaways:

  • An emergency fund is a saving worth three to six months of your expenses that you’ll use during a financial emergency.
  • If you’re still paying off your debt and can’t build your full emergency fund amount, start with at least $1,000 if you’re in the US or P10,000 if you’re in the Philippines.
  • Save your emergency fund on multiple banks and have a cash stash at home.
  • Be honest with what you consider an emergency.

What’s next?

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