Today’s money hack is related to saving money for emergencies in order to prevent accumulation of debt.
Life is full of unexpected twists and turns, more so for people at the bottom of the pyramid. At every step of the way, consumers may feel the need to rely on some form of debt to cover their expenses. When it comes to foreseeable expenses, like groceries and utility bills, one can manage without accruing vast amounts of credit card debt or consumer loans. The story does not end here, however.
When it comes to unforeseeable expenses, the financial damage can be crippling. A hurricane may damage your house’s roof, a road accident may wreck your car, you may develop a serious health condition that requires an extensive treatment plan, or you get laid off from work. Many people rapidly accumulate a lot of debt trying to cover these expenses, which can set them back many years in terms of financial independence.
This is where the concept of an emergency fund comes in…
Emergency fund – definition, size/amount and maintenance
To meet these unexpected expenses without losing all your assets and hitting a financial sinkhole, you need an emergency fund. This is essentially ‘backup money’ that will keep you away from debt, to whichever extent possible.
Many personal financial bloggers will tell you that the benchmark amount in your emergency fund should be around 5 or 6 months’ worth of expenses. To simplify it further, you can place half a years’ worth of salaries in the emergency fund and then walk away from the money money until you really, REALLY need it.
Once you have this money in place, add to it over time. If and when you do end up using the money from your emergency fund to meet a big ticket expense or every day expenses, replenish the amount as soon as possible. Dave Ramsey advises it is better to keep the emergency fund in a liquid state, i.e. cash in a bank account you can access quickly in your time of need.
Emergency funds offer two major benefits, which we discuss next.
1. Benefit of emergency fund #1 – it can prevent debt
With debt being labelled as a modern day equivalent to slavery, it is crucial to do everything in our power to stay debt free. Few adults would willingly accrue masses of debt that they are unable to repay, yet millions of people are trapped in debt that threatens to bankrupt them.
2. Benefit of emergency fund #2 – it can offer peace of mind
Knowing you have a backup plan in case things go south alleviates a lot of stress from your life. One can never be fully prepared for life’s surprises but keeping an emergency fund as an insurance against financial shocks can help you sleep a little better at night.
3. Benefit of emergency fund #3 – it teaches frugality
The process of setting up an emergency fund forces you to cut back on your current expenses and direct that money towards a separate savings account. You learn to stretch every dollar as you try to save as much money as possible to add to your emergency fund. The exercise encourages a pro-savings attitude which is a great approach to managing personal finance matters in general.
Read more about building an emergency fund at Investopedia.