A key financial priority for most people who wish to manage their money prudently and responsibly should be the accumulation of an emergency fund. If you have gone through unexpected life events that hit you financially, you know how unpleasant they can be and how stress they can put on you. Having a buffer to respond to unplanned spending can put your mind at ease and save you from resorting to debt.

The content of this post does not constitute financial advice. It is intended for educational purposes only.

What is an emergency fund and why do you need it?

It is a reserve of cash set aside to be used only when there are unplanned emergency situations that need to be addressed immediately or on short notice, which helps you avoid having to give up on or postpone your financial goals or having to resort to debt. The emergencies can range from health-related expenses, home repairs, and unexpected family needs, to job loss and unemployment, vehicle breakdown, or essential device replacements (laptops, phones, etc.).

An emergency fund provides you with a sense of comfort that if one of these situations hits you, you will be well prepared to handle it. It is your safety net for when things go wrong and provides coverage for those things, against which you might not be insured or have social security, for instance, or are just impossible to anticipate in advance. In that sense, an emergency fund is in essence a risk management tool.

To summarize some of the key reasons why or cases in which you would benefit from having it:
– It provides protection against unexpected expenses and unplanned emergency situations
– If you don’t have other funding sources or assets to use in case of emergencies, it gives you a reliable savings pot to draw on
– You know from your history these events have happened to you (for example, you might have a complex medical history) and there is a relatively high likelihood they could happen again
– You care for other people (children, elderly people in your household, sick people) and that often leads to unexpected additional spending
– You own assets that cause you to incur occasional unpredictable costs
– Your income is irregular, which could put you at risk of paying for the absolute necessities in some periods
– You want to avoid resorting to debt when things go wrong
– You want to have a reserve for positive surprises, such as trip invitations, parties and gifts, spontaneous events, and holidays

Data show that people across various regions in the world often do not have sufficient savings to cover longer periods of financial emergency or sudden unemployment. Below you can see some survey results from the United States and the European Union from 2023, which show that for the majority of respondents, in case of a financial need or loss of income, about 33% of EU residents and about 30% of Americans can afford to pay for 6 months or more of their expenses. That number varies widely across countries and income groups, of course. But in general, these outcomes are very concerning, especially for those less well-off, as that means that when hit with a financial shock, they could end up in severe distress and might have to resort to debt.

How much should I put in it?

To answer this question, you will need to understand your financial situation first. You could start by examining your income and expenses and understanding their regularity. Take a look in particular at the irregular and unexpected items on both sides, especially the outflows (you can budget for the regular ones). Any past emergencies and irregular spending – their magnitude, the situation in which they occurred, and periods in which they most often happened – can give you an idea of how much on average you might need to cover in an emergency.

My suggestion is that most people should build an emergency fund that can cover at least 6 months of their regular expenses + about 2-4 times the average monthly emergency/irregular expenses over the last 2-3 years. You could of course tailor that based on what you can afford to cover, the availability of other funding sources, or other factors, such as forward-looking information about your personal situation and needs.

You can turn this number into a financial goal to which you assign the highest priority. Of course, the speed with which you can accumulate the fund will differ depending on how high your income is and what your savings rate is. For example, living paycheck to paycheck is a situation in which this can feel like a very challenging goal for you. But even going slowly and persistently can go a long way to achieving it and help you immensely, should the unexpected happen. Ideally, your contributions to the fund should take precedence over discretionary spending and most other financial goals.

What is the right way to build an emergency fund?

When trying to build an emergency fund, I would suggest that you focus on the following core principles and aspects, as this will ensure that the fund is prioritized, used properly, and accessible when it is needed.

1. Debt and retirement savings are no emergency fund
The point of the existence of an emergency fund is that it serves as a reserve that helps you avoid the use of debt, not something that pushes you towards it. Unfortunately, a lot of people treat a credit card or an overdraft as emergency funding and that starts for many of them the slippery slope of an ever-deepening debt spiral. Others dip into retirement accounts and take advantage of those savings to cover emergencies, which is also detrimental to their wealth-building efforts and can be linked to even more additional costs.

2. Emergency funds need to be held separately
This means, separate from not just retirement and other savings accounts, but also separate from your checking account that you use to make regular payments and cover regular expenses. Mixing day-to-day cash and reserves for emergencies can confuse you and even tempt you to use the latter for more casual spending, and then lose track of what you actually have available for emergencies.

3. Prioritize it as a goal
You should not just put cash in it when it suits you or on convenient occasions because this way you might never build it properly by the time you need it. And if you use it up or partly, make it a priority to replenish it as soon as you can.

4. It is better if your contributions are systematic, and ideally automated
You can set up a recurring automatic transfer from your account once you receive your salary or other cash inflows. You can use some other less frequent recurrent money flows to contribute, too – such as bonus payments, paybacks from friends, cashback for purchases, interest on deposits, rent income, and other windfalls. Even if there are one-time payments or non-recurring sources of income, you can still set a portion (a rate, e.g. 5-10% of each such inflow) for yourself to put aside.

5. Requirements for the assets in which you can hold your emergency savings
– liquidity – the assets need to be able to convert quickly, easily, and without additional cost into cash
– accessible – there should be no obstacles to withdrawing or selling (such as legal ones)
– safety – whatever you hold your funds in, it should have low price volatility and low-risk characteristics (e.g., credit/default risk), which can be achieved if the savings are insured as part of a depositor protection (or similar) scheme
– taxation – tax burden should be minimal, if possible (which could depend on the treatment of the returns, distributions, and type of account)

6. Earning yield
It is not a requirement to earn yield from your emergency fund, as it is on other investments, as the previous requirements mentioned in point 5 are much more important – remember the purpose of this savings pot. Nevertheless, if there are suitable instruments offering some yield that will help the emergency fund grow (so you don’t have to suffer the full opportunity cost and inflation cost), while still having the other characteristics, then they are preferable. You should also ensure that there is no cost to such alternatives.

Examples of accounts or assets that could be suitable for emergency funds:
– Without yield (or very low yield): Checking account (in Germany: Girokonto)
– Higher yield but not always immediate availability: Short-notice/flexible savings account or Money Market Deposit Account (in Germany: Tagesgeldkonto/Flexibel Tagesgeldkonto)
– Investment flexibility with variable availability depending on the brokers: Uninvested cash balance programs that earn interest with broker companies

There could be other options available that might be suitable in various situations. However, they would usually sacrifice either liquidity or safety or some other required characteristic for yield, for instance, which can also make them less reliable in case of emergency. Hence, they need to be considered on a case-by-case basis and depending on the individual