Most people know that they should have an emergency fund stored away in case of financial problems. Although there is some disagreement about how large this fund should be, many say that it should be enough to cover at least three to six months of living expenses. The truth is that the right amount can vary with the individual. While too much savings is certainly preferable to too little, an overly large emergency fund can actually cause some problems.
Planning for an Emergency
Emergency funds are generally created as safeguards against unemployment, which has been shown to last an average of eight months. Otherwise minor expenses, such as auto repairs or dental procedures, could be devastating without either an ongoing supply of income or enough savings in place. At the same time, long-term absence of income can be managed more effectively by developing a budget for such a situation.
To create an emergency budget, one should list out all routine expenses and decide which can be eliminated to save money when necessary. This can extend the useful life of an emergency fund until income returns to normal levels. Other strategies that can minimize savings expenditures include freelancing and taking temporary jobs.
Accounting for Surprise Expenses
Job loss is far from the only reason for having to dip into emergency funds. Costly medical care or critical repairs may arise, exceeding what your income covers. Having enough savings can prevent financial destitution or hardship in these cases. Unfortunately, fully accounting for possible emergencies borders on impossible.
Besides costs associated with medical care and vehicles, many people face emergency expenses involving their housing, children and other events. Some financial burdens, such as births and deaths, are inevitable but not always easy to plan for before they arrive. One way of addressing these events is to budget individually for them. For example, one can create budget categories for vehicles, home expenses and medical care and set money aside with each paycheck. This will greatly reduce the impact that unexpected costs can have on savings.
Problems Caused by a Too-Large Emergency Fund
Considering that an emergency fund can last significantly longer than expected if certain measures are taken, what problems might an overly large emergency fund cause? After all, nobody can deny the feeling of financial security that such savings can give. Problematic aspects of huge emergency funds basically boil down to issues of inflation and opportunity cost.
In the average year, inflation rises about 3 percent. This may not seem excessive at first glance, but it can have major effects as savings accounts grow larger. First, it is important to note that 3 percent inflation dwarfs the 1 percent rate of interest that even the top savings accounts offer. Each year such a savings account is maintained, about 2 percent of it is essentially being depleted by inflation. Of course, inflation also compounds, which means that a $15,000 savings account with the listed rates of inflation and interest would be reduced by one-third over 20 years.
While the potential for financial emergency demands preparation, one must also consider that many people will not be forced to use their savings in a normal 20-year period. Such a scenario would mean that significant money has been lost to inflation, highlighting a major loss of opportunity in that period. How might those savings have been better spent? One should recognize that investing that extra money would have been the better option in the long term.
Smart Moves for Emergency Fund Maintenance
Even with limitations related to long-term savings in the face of interest, a savings account is a crucial part of smart personal finance. Still, one must remain aware of the problems that can accompany an emergency fund once it grows too large and lasts too long. Prudent use of mutual funds is a great way of addressing this issue. So, how can one determine the point at which funds should be diverted to mutual funds?
This is a personal decision that individuals must make based on their comfort levels. For those who feel most secure with plenty of savings stashed away, an emergency fund on the larger side may be ideal. This is particularly true when funds have already been set up for retirement and other long-term investments. For those whose retirement accounts are currently lacking size, more diversion of emergency funds to long-term investments is probably preferable.
No matter which route is taken with an emergency fund, regular payments to savings are essential. Continual contributions to savings will pay off eventually whether or not an emergency occurs. By paying attention to the size of this account and making adjustments with regard to other investments when necessary, one will achieve the highest levels of financial security.
The potential downsides of excessive savings accounts are rarely mentioned. However, a majority of workers fail to maintain even the minimum levels of emergency funds and should work on developing a basic security net before starting to limit it. Once this fund is created, one can taken several steps to stay financially safe, including making emergency budgets and setting savings limits at which other investments should be sought. In the long term, these savings offer rewards not only in financial stability but also in peace of mind.
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