There is no telling what the future holds. It might bring boon, or it might bring bane. Regardless, it is best to always be prepared. Planning for the unexpected is a fundamental concept in personal finance, one that necessitates starting and sustaining an emergency fund.
An emergency fund is money set aside to cover financial contingencies. It is your safety net against unexpected expenses that could leave you financially worse off. Having an emergency fund can help ensure that small snags and minor hitches in your financial journey need not spiral out of control and turn into catastrophes that can ruin you for life.
If you are still unconvinced of its value, and are unsure if you need to invest in one, here are the most important benefits of an emergency fund.
1. Cover lost income
Among the more prevalent and prominent benefits of an emergency fund is as an insurance against loss of income, whether as a result of unemployment, illness, or accident. Having enough money set aside to cover at least several months of basic expenses helps ease the burden of rough economic times by tiding you over until you are able to return to work.
Although building an emergency fund is a worthwhile endeavor for all people, it is a must if you only have one source of income. Should you lose your only source of revenue, having an emergency fund set aside helps mitigate the impact of what could otherwise be a financial catastrophe.
Likewise, if you are self-employed, an independent contractor, work a job without unemployment benefits, or work in an industry with a high turnover rate, an emergency fund acts as a buffer against inconsistent, reduced, or lost income. Ditto if you are single or if you cannot rely on the assistance of financially stable people should you find yourself in dire economic straits.
The benefits of an emergency fund are even more evident if you are the sole provider of your family. Should you suffer a job loss, having enough money reserved to cover several months of living expenses helps you and your family maintain your standard of living (or at least close to it) until you are able find new employment.
2. Pay for medical emergencies
Another of the more common benefits of an emergency fund is as a safety net for medical emergencies that can leave you financially worse off. After all, accidents and illnesses can happen to anyone. Although a healthy lifestyle – wholesome diet, regular exercise, good hygiene, sufficient sleep, and whatnot – can help reduce the likelihood and severity of certain sicknesses and disorders, it cannot guarantee complete immunity to all medical conditions.
Medical emergencies can be very costly, and in extreme instances, can become the ruin not only of your physical health, but also of your financial well-being. Relying on your health insurance may not be enough.
Depending on the nature of your health insurance, you might be required to pay out a substantial amount of cash as part of your deductible before your health plan takes over the rest. Or if you are enrolled in a health plan that pays via reimbursement, then you need cash on hand to settle your medical expenses before you can file a reimbursement claim. You might also be required to pay for the rest of your medical bill if your health plan simply cannot cover all the costs. Bear in mind, too, that some medical procedures might not be covered or are only partially covered by your health insurance.
The benefits of an emergency fund set aside and easily accessible is that it helps you not only pay for unexpected medical expenses, but also cover lost income should your injury or illness keep you from working – and earning – for some time.
3. Pay for other unexpected expenses
Beyond being able to cover lost income and pay for medical emergencies, the benefits of an emergency fund extend well into other unplanned but nonetheless essential expenses.
A case in point – maintaining a home. The cost of owning a home goes beyond paying for the mortgage. You have to take into account the cost of maintenance and repairs, too. From fixing a clogged up toilet, replacing a malfunctioning air conditioning system, repairing a leaky roof, to removing a fallen tree, home ownership involves a lot of unplanned expenses, and sometimes, your homeowners insurance might not be enough. Depending on your insurance policy, you might need to pay out a high deductible, or worse, your home emergency might not be paid for by your plan at all. Thus, why you need an emergency fund ready.
Similarly, vehicle ownership entails maintenance and repair costs. From changing the engine, replacing a blown tire or a dead battery, to repairing an overheated engine, auto repairs can very costly. Having an emergency fund accessible for just such sudden expenses is exceedingly helpful, particularly if your warranty or auto insurance covers only part of the costs, or worse, none at all.
Other unanticipated but important expenses where the benefits of an emergency fund are evident include last-minute travels, unplanned visits to the veterinarian, unexpected tax bills, or even a lawsuit. The bottom line is that for most types of financial emergency, having an emergency fund built-up and readily accessible can spell the difference between a small bump in your financial journey and a financial catastrophe with lifelong effects.
4. Avoid taking on debt
Doubtless the most important of all the benefits of an emergency fund is that it reduces or even completely eliminates the need for you to resort to debt should you find yourself in a sudden money crisis. Or if you already have debt, then an emergency fund helps you stop adding to it.
Having money set aside for financial contingencies helps you avoid incurring costly debt, such as relying on your credit card or taking out a payday loan, two of the costliest debt owing to the high interest rates involved.
Although using your credit card to bail you out of unexpected financial trouble can be viable, it comes with plenty of risks, foremost of which is the need to pay interest on your borrowings until you can repay the whole amount. You also risk going over your credit limit, and if you are unable to pay the balance on time, risk incurring penalties on your credit score.
On the other hand, taking out a payday loan is not advisable, as you have to deal with the almost exorbitant interest rate. Worse, since you have to pay the amount owed out of your next paycheck, you risk creating a possible cash shortfall, which you might be tempted or forced to cover by taking out another loan, burying you deeper in debt.
While credit can be an option during a financial dilemma, if you have no realistic plan of repaying your debt on time, then you only risk exacerbating your money woes. Late or missed payments and penalty fees negatively impact your credit score, drastically affecting your borrowing options in the long run. Remember, too, that being in debt can take a heavy toll on your physical and mental health.
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5. Earn interest
Among the overlooked benefits of an emergency fund is that it actually allows you to earn money. Although financial profit is not the raison d’être of an emergency fund, when you save the money on an account that earns substantial interest, it grows in value over time. The more money you have in your account, the more interest you earn, but the type of account (and interest rate) will also determine how much interest you earn.
Remember, however, that you have to have quick and easy access to your emergency fund, so avoid putting it on high-risk or non-liquid investments. For instance, it is not advisable to invest your emergency fund in stocks, because although these can earn you higher interest, you also risk losing part or even all of your money!
On the other hand, while the underside of your mattress might be a safe and convenient hiding place, you still need to contend with the value-eroding effects of inflation. Thus, you need to place your money in an account that is not only easily accessible and relatively safe from market risk, but also earns you enough interest to offset inflation.
If so, a regular savings account, which pays negligible interest, simply will not do. Instead, a high-yield savings account should be your first choice. You can also invest in a money market account. In both options, not only are you guaranteed immediate access to your money the moment you need it, your emergency fund also keeps earning interest and growing in value.
You can also choose to invest your emergency fund in Certificates of Deposit (CDs). These offer you the opportunity to earn more than high-yield or money market accounts, but the drawback is that you might incur a penalty fee if you withdraw your money too early.
6. Avoid overspending
Another of the often overlooked benefits of an emergency fund is that it helps you rein in overspending and develop good money habits. When part of your money is allocated towards an emergency fund, you limit the budget you have for day-to-day expenses. You force yourself to make do with what is left, encouraging yourself to become prudent and creative with your money. You start thoroughly evaluating your spending habits, identifying expenses you can do without, and making cuts accordingly.
In addition, having your emergency fund placed in an account separate from your regular checking and savings accounts (or whatever account you keep your money for day-to-day spending in) reduces the temptation to spend it on trivial and frivolous purchases – the exact opposite of emergency expenses. By keeping your money out of your sight, you also keep it out of your mind – until, of course, the need arises.
Moreover, setting aside money specifically for emergency expenses helps you avoid dipping into other savings earmarked for other equally worthwhile purposes, such as a down payment on a house, starting a business, or more important, retirement. With an emergency fund, you not only avoid sabotaging your other financial goals, you also ensure that you are on track to fulfill them.
Finally, having an emergency fund allows you to spend less, and hence save more money, on various insurance policies – health, homeowners, auto, and whatnot – since you reduce the need to rely on such plans to cover absolutely everything should you find yourself suddenly mired in financial mess.
7. Relieve stress
One of the invaluable benefits of an emergency fund is the peace of mind that it affords you. While an emergency fund might not completely cover all of your unplanned expenses, it can help ease the burden of unforeseen financial difficulties. It provides you with a sense of security by reassuring you that you can weather the storms of life. And when disaster does strike, you need not worry how and where to find the money to bail you out.
Besides, knowing that you have an emergency fund to tide you over should the worst happen allows you to go about your life with more ease and confidence. Instead of worrying about your personal finances, you can devote more of your attention to improving other aspects of your life. It also gives you the freedom and courage to take on risks you would not otherwise do, particularly risks that can reap you financial gain.
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