Emergency funds, as the term suggests, are those funds which are accumulated over a period of time so as to meet any contingency and for financial security. These funds come handy when you fall ill or due to any disability, you cannot work or you loose job. Emergency fund can help in payment of huge medical bills or home repair bill. If one does not have enough money during such contingencies, there is likelihood of falling in debt trap as you have to borrow at high rate of interest. Nobody wants to land in such a position where one has to buy household necessities on credit.
To start an emergency fund, a simple deposit of $100 may suffice. But make sure it becomes a habit and you deposit this amount regularly.
Now, the question arises how much money one should have in the Emergency Fund. It is prudent to keep at least six months’ daily living expenses in the Emergency fund. If one is single and does not have dependents, then even three month’s worth of expenses can be kept in the Emergency Fund. But if you have a family who depends on your income, then you need to save enough funds to last for at least six months. Another factor to take into account is the nature of your job. If the job is secured, one need to keep minimum of three to four month’s of expense. But if the job is insecure or in such industry where lay offs are often, then one must be prepared to keep aside higher amount in Emergency Fund. Also, if you do not have short term or long term disability insurance which helps in paying some part of your salary in case of disability, then the amount which goes into your Emergency Fund should be increased accordingly.
It is prudent to separate emergency funds from other savings viz, savings for a vacations, wedding, home improvements, a new car. This will help in avoiding temptation to spend from Emergency fund.
Next, you must think about where to park Emergency Fund. It is wise to invest this money in such an instrument that gives good return as well as is safe and liquid. You must be in a position to retrieve these funds at short notice. You can keep these funds in saving account, money market funds, short term bonds, certificates of deposit. If one has enough knowledge of stock markets, one can invest in stock market as it is also liquid asset. But this may be a loss making proposition if you require funds when the market is down or you have to sell stocks at discount.
The success of building an emergency fund lies in consistency in saving on a regular basis and resisting the temptation to spend from emergency fund for some other purpose other than on emergencies. You can start accumulating funds for emergency any time, sooner the better. Decide on how much cushioning you require, then do not touch those funds and put these funds in safe place.