Emergency Fund 101: Do You Need One?

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APRIL, 2018
AK Equity Group
An emergency fund is a portion of money you set aside to cover life’s inevitable curve balls. Without an emergency fund, these unexpected events, such as a job loss or flooded basement, can be stress-inducing and costly.
In addition, having an emergency fund to cover sudden, unforeseen expenses can help you better stay on track with your long-term financial goals; it means you don’t need to disrupt your long-term investments to cover short-term financial surprises.

What exactly IS an emergency fund?

An “emergency fund” could be as little as $1000 you’ve set aside. Ideally, though, your emergency fund should be the amount you need to maintain your normal life style for 3-8 months, should your main source of income be reduced or interrupted entirely.

This money exists for the sole purpose of covering the emergencies that life hands you, allowing you absorb extra unforeseen costs while continuing to maintain your normal life. It is not meant to be used for splurges, such as a new big screen television or a vacation, but rather should remain untouched until you actually need it.

Low Risk, High Liquidity

Most people set up a separate savings account for their emergency fund. While a saving account has a low rate of return, usually between 0.5%-1%, it has other qualities which are vital for financial emergencies.

First of all, in a savings account your cash is highly liquid. If you need money at a moment’s notice, you can simply withdraw it. You may have other investment products that are providing a much higher rate of return, but many of them are not structured for quick withdrawals and can include costly penalties for doing so.

Secondly, a savings account is low risk, which helps ensure that you can count on the full amount to be there whenever you need it. This is why investments with higher volatility- even if they are liquid- are not necessarily viewed as ideal emergency funds; it’s possible they could dip in value at the moment you need the funds.

But what about investing?

An emergency fund kept in a savings account will not garner a high rate of return, it’s true. However, it’s important to remember that you shouldn’t be keeping a significant portion of your net worth in an emergency fund. It should comprise only a small fraction of the total value of your assets; 3 month’s worth of living expenses is sufficient.

In this way, the fund represents a minor sacrifice of returns in order to keep a small portion of your money on hand in a low-risk and liquid form.

An emergency fund represents a minor sacrifice of returns in order to keep a small portion of your money on hand in a low-risk and liquid form.

What about credit?

Some people feel that having access to credit- either through credit cards or a line of credit- provides them with the same security as having a saved emergency fund. But there are a number of downsides to relying on credit in emergencies.

First, just because you have a certain amount of credit available to you through your financial institution doesn’t mean this it will always be there. A bank could change their policies, re-evaluate your credit-worthiness, or even change ownership. Any of these events- which are outside your control- could mean that the funds you assume will be available might not be.

Second, in the unlikely event that you experience identity theft, you could experience a serious impact on your credit. This could lead to the loss of certain existing credit cards or lines of credit.

So there are some scenarios where a credit-based emergency fund would introduce certain risks, which undermines part of the purpose of an emergency fund. The aim is to have one portion of your finances designed to have the absolute minimum risk.

No matter what phase of life you’re at, an emergency fund is an important part of sound financial planning. When you set aside sufficient liquid assets to cover the surprises life throws your way, you gain peace of mind and strengthen your overall financial stability.

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