What is an emergency fund?
Two years ago, I decided to resign from my job. It was a long time coming, but on my last day, I had not lined up a new position and had instead decided to take some time off and focus on me. I did not have another source of income and had a rather long list of bills. It was a scary move, and you are probably wondering why I thought this was a good idea. If this were 2015, I probably would not have resigned until I found a new position. I would have stuck it out because I needed to pay the bills.
However, in 2016, my friend and financial advisor, Edwin, convinced me to start an emergency fund. An emergency fund is a readily available pool of money that helps you navigate unforeseen financial dilemmas. It caters to any financial shocks that may occur, like unemployment or your business having a low season or going bust, medical expenses, major repairs, or expensive replacements of assets, among others. Should your income decline, like many individuals and businesses during this pandemic, your emergency fund gives you some breathing room to keep things going as you figure out your next steps.
How much should you save?
The rule of thumb is to have 3 – 6 months’ worth of expenses saved up in your emergency fund, but it can be any amount that cushions you from financial shocks. You could save for the costs you must pay like rent/mortgage, utility bills, groceries, school fees, loan repayments, and insurance. Or you could include wants and lifestyle expenses. Either one works. Financial goals are personal and should be crafted based on your means and needs.
How do you build up your emergency fund?
Now that you have identified your target amount, the next step is to plan how you will build up your fund. To do this, understand your incomes and expenditures so you can properly structure the fund. As with all habits, consistency is vital.
When I started, I was comfortable putting in 10% of my salary towards the emergency fund. I would also put 30% of my annual bonus and 50% of any revenue from side hustles towards the emergency fund. Another tactic I used was sweeping the balance of my account at the end of every month. Any amount left before the next salary came in went into my emergency fund. This way, it took me about 18 months to build up my emergency fund to 6 months’ worth of expenses. My expenses change every year because of inflation, new costs and my indefatigable travel itch so I am continually beefing up the fund, albeit at a lower amount than when I first started.
There are a lot of ways to put money towards your emergency fund. You can use the 52-week savings challenge, do direct-debits to a savings account, or save the change in your pockets at the end of every day. It may sound like small amounts, but it adds up. “Haba na haba hujaza kibaba.” The idea is to start. No matter how little you can put toward your savings, start. The habit you’re creating will transfer even when you have more disposable income.
Another great tip about making savings is to match it to your revenue cycle. If you earn money daily, save a percentage of your daily income. If it is monthly, save monthly. It is easier to do this than trying to make lump sum savings against your cycle.
Where do you keep your emergency fund?
My bank automatically sets up a savings account for you when you open a current account. At first, I would save my money there. I must admit, until I met Edwin, I was very comfortable with this arrangement. My money was safe, and I had relatively easy access to it even though I didn’t have a debit card, mobile, or online banking linked to the account. It wasn’t even in a fixed deposit account, and I doubt I ever made any more than KES 500 on the balance of the account. I was satisfied counting the zeros in my bank account until I learned the value of compound interest.
Compound interest allows your money to work for you. Compounding makes a sum grow at a faster rate than simple interest. In addition to earning returns on the money you invest, you also earn returns on those returns over time. So when you save your money in an interest-earning account, you not only earn interest on the amounts you save but also on the interest earned over time.
Kenyan banks are not doing great at rewards for having balances in your savings account. With the interest rate cap law repealed in November 2019, the interest rates on bank balances have dropped significantly. It is, therefore, advisable to look for other investment vehicles. Good options are Money Market Funds, Unit Trusts, Treasury Bills/Bonds, Fixed Deposit Accounts, Equity Funds, and high-interest savings accounts. Whatever option you choose, conduct thorough due diligence, make sure your money works for you, and separate your fund from your daily expenses to avoid dipping into it. Additionally, because it is an emergency fund, ensure you can access your money easily should the need arise.
When should you use money from your emergency fund?
When is it appropriate to withdraw money from the fund? Retail therapy, paying for a wedding, regular car service, or renovating your house are not emergencies. You could have saved for them or used insurance for emergencies like health care, damage, or loss of property. Your emergency fund takes care of high unforeseen financial costs. Before you tap into your emergency fund, ask yourself if the situation at hand is unexpected, if it is necessary, and if it is urgent. If all your answers are yes, then you can use the emergency fund.
Having a robust emergency fund gives you some breathing room when the unexpected happens. It is the difference between experiencing financial stress when an unexpected expense comes up and a small bump in your financial life. Start your journey today. How much do you need to save? Ok now, let us set up some goals. Assuming it will take you 18 months to save this amount, so how much do you need to save monthly, weekly, daily? Where will you keep your money? Set up that new savings account, buy that piggy bank, or open a unit trust account. You are good to go. Happy saving!