When you’ve read about finance and investing before, you probably stumbled upon the term “Emergency Fund”. We at Lendermarket also mention it quite often. It’s definitely something that makes you sleep better at night.
In this article, we’ll discuss what exactly an emergency fund is, why you need it, and how big yours should be. We’ll also discuss whether you should invest your money while building your rainy day fund and if it makes sense to pay off your debt first.
What Is an Emergency Fund?
An emergency fund is money you saved and set aside for when the worst case happens. This could be your car breaking down and you need to pay for repairs, a critical home appliance like the washing machine requiring maintenance – or even losing your job.
The emergency fund money, sometimes also called the rainy day fund, should be easily available at any time and not volatile. Therefore, your investment in stocks, P2P, and crypto is generally not seen as contributing to your emergency fund. We’re talking about cash and money in the bank.
Why Do You Need an Emergency Fund?
The biggest argument pro emergency fund is that it will save you countless costs. Why? Because if your car breaks down, and you need to take up a loan for it, you have to pay high-interest fees. With the emergency fund, you can save money and refill the fund over the coming months.
Some people also call the money in the emergency fund fuck-you-money. This sounds more vulgar than it needs to be, but the idea is that the money allows you to make a different decision because you don’t need to care so much about a specific outcome.
An example often used:
Imagine you’re at a job you like, and one day there’s a new colleague who keeps bothering you. You try handling the situation through all the right channels, but to no avail. The emergency fund gives you the option to just quit and leave that environment, without needing to worry where the money for the next couple of months will come from.
The same goes for a toxic relationship. With the emergency fund stashed away, you have the freedom to just leave, rent your own space etc.
How Big Should Your Emergency Fund Be?
The size of your emergency fund can be determined in two ways: Either by looking at your income or your expenses. Let’s look at the pros and cons of each method together.
Approach #1 – Going by Income
The most common rule of thumb you hear on the internet is: Your emergency fund should be as high as 3 – 6 monthly salaries. Of course, it can also be 12 salaries big, if you want to play it more safely.
The thing is, it focuses on income. If you spend all of your income every month, then this can be a great approach that doesn’t need much thinking. On the other hand, if you earn 5000 EUR a month but only spend 2000 EUR, then the money might be spent better.
|Easy to calculate
Don’t need an overview of your expenses
|Potentially saving too much → Leaving returns on the table
Approach #2 – Going by Expenses
An option, to be more precise, is to base the amount you need for your emergency fund on your expenses. The big requirement is, however, that you need to know what you spend. Perhaps you’re already using an income and expenses tracker for your finances, then that is easy.
Otherwise, take a look at your bank account and credit card statements to see how much money is flowing out of them every month. You see, this method requires more planning and thought but frees up more capital to invest.
Pro-tip: Perhaps your emergency fund doesn’t need to cover all regular expenses but only food, rent, and insurance? Then it can be even smaller.
Freeing up capital to invest and make returns
|Needs more time investment to put together
Where to Put the Money From the Rainy Day Fund?
The money in your rainy day fund should be easily accessible and available on short notice. That means the following options work for this:
- Your bank account
- Overnight Savings Account
If your emergency fund has reached a certain size and covers 6 -12 months of your expenses, you might not need to have access to all of it at once. Then you can also consider using the following ways:
- Short-term government bonds
- Money market funds
- Fixed deposit
Should I Invest While Saving Money for an Emergency Fund?
Whether to invest while you’re still building your emergency fund depends on your personality. If you are risk averse, it might bring you more peace of mind knowing that you have 5000 EUR set aside that you can fall back to when needed.
If you’re more of a risk-taker, you might decide to only save a certain amount of money each month for a year (say 400 EUR) until your emergency fund is full, and invest the money you have left after that.
Also factor into that equation the cost of your lifestyle. If you don’t mind buying a used phone for 100 EUR when yours breaks, or you can fix stuff around the house yourself, you’ll be less exposed to spontaneously spending high amounts compared to someone who doesn’t know their way around tools or needs the latest tech.
Pay Back Debt Before Starting an Emergency Fund?
Paying back debt yields you guaranteed returns because you won’t have to pay the interest. If you have high-interest loans with 10%+ then paying them back before starting the emergency fund is a no-brainer.
Even beyond that, paying back debt is always a great choice. Sometimes the rates, however, are limited, and you can only pay back a certain amount per month. Then it makes sense to start the emergency fund parallel to paying off your debt.
Conclusion: Everyone Should Have an Emergency Fund
When you start learning about finance, one of the first things recommended is to build an emergency fund. And we wholeheartedly agree. The peace of mind that comes with knowing you can survive on your savings for a bit and don’t need to take up debt if trouble occurs is priceless.
As a general rule of thumb, your emergency fund should be 3 – 6 months of your income, easily available, and started before you start investing. Make sure to pay off your debt first, though, as that’s a huge leverage for your net worth and well-being as well.