Q: I have been working in the corporate world for some time now but I don’t seem to have enough savings in my bank account. I am afraid that I may not have the cash to pay for unexpected events when I need it. What should I do? – Buena, by email
Building an emergency fund is an essential step in personal financial planning. This is the fund that you set aside from your savings to cover any unexpected financial dilemma resulting from personal crisis.
Crisis can happen to anyone. You may suddenly lose your job, or face an unexpected illness or accident, which may require you to shell out major cash outlays to sustain your expenses for the next few months. When this happens, the last thing you need is additional stress to look for someone to lend you money.
Having an emergency fund is having peace of mind. The purpose of building a fund is to improve your financial security. You may not have enough savings in your fund to handle all financial shortfalls, but at least having the discipline to save and build a fund can give you a sense of security and help you lower the amount of emergency money in case you need it.
How do you get started in building your emergency fund? Here are the five tips everyone should learn when saving money for emergency use:
1. Decide how much you need
The standard recommendation by financial planners is to have an emergency fund that can cover at least three months of living expenses. For example, if your monthly expenses amount to Php50,000, you need to build up your savings up to Php150,000 as your standby fund.
However, given the uncertainty of emergency needs and rising costs of services, three months may not be enough to sustain your financial shortfalls. You may need to increase it to at least six months’ worth of living expenses to have a comfortable buffer fund.
2. Decide how to allocate savings
Most people will spend first the moment they receive their paycheck and save later. Very often, there is almost nothing left to save by the time the month has ended.
When you decide to save, make the commitment to pay yourself first. Set aside a portion of your monthly income; let’s say 10 percent, before you spend the balance for your personal expenses. You can open a bank account just for this purpose and start saving automatically.
3. Decide how to invest the fund
Once you have enough savings in your bank account, you need to invest it in order to grow. Keeping all your money in the bank will not do you any good because the returns are negligible. You need to make your money work for you at the best returns possible.
Because this is an emergency fund, you can’t ask for so much also. Normally, higher yield investment requires long-term commitment. For example, investing in a seven-year bond that pays seven percent interest may not be ideal for financial buffer because terminating it prior to its due date for emergency purposes may result to capital losses.
You can invest a bulk of your savings in money market funds that earn higher than a regular savings account. Diversify the other portion of your savings into preferred shares that pay relatively high dividends and maybe some blue chip stocks.
4. Decide where to keep the fund
In principle, when you build your savings for your emergency fund, you must keep it in any investment vehicle that is low risk. You cannot afford to invest your emergency fund in a high-risk, high-return investment because you don’t want to incur losses in the event that you badly need it.
You must also make sure that you keep your funds in liquid investments. You must be able to easily access it and liquidate immediately in case of emergency.
For example, choose money market funds that will allow you to discharge the next day without termination costs. Keeping some of your savings in preferred shares will also allow you to liquidate easily by selling your shares in the stock exchange anytime.
5. Decide how the fund will be used
If you have a sizable emergency fund, you can divide it according to short-term and long-term purposes. You can allocate a portion of the fund to take care of your small financial emergencies. In this case, you can keep the funds in low-risk, low-return and easy-to-liquidate investments.
You can make up the low-returns by investing a portion of your emergency fund for larger financial needs. While accessibility is still important, this one may take few more days to liquidate because of commitments with the bank. This type of investment earns relatively higher returns than the short-term funds.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice firstname.lastname@example.org or follow him on Twitter @henryong888