Preparing for Emergencies by Starting an Emergency Fund

 

Introduction

When the Federal Government was considering nationwide lockdowns during the heyday of the COVID-19 pandemic, some of us insisted that the economic and mental consequences of such lockdowns would exceed the supposed benefits.

In a Whatsapp group I belong to, one of those who didn’t agree with this view - that the lockdown's economic and mental consequences will exceed any supposed benefits - upbraided Nigerians for not preparing for emergencies. He believed that Nigerians don’t learn how to save for situations like the pandemic.

While that discussion was ongoing, it was easy to see the elitism in his argument. How many average Nigerians earn enough income to get by their living expenses, talk less of saving? A whopping 40% of the population lives below the poverty line, according to the NBS. So that upbraiding was by and large inconsiderate.

However, it will be naive to think that we don’t have some people who can prepare for emergencies but find themselves unprepared when the COVID-19s of this world hit. So while we take the millions of people who hardly survive with their income into consideration when making policies, there is also a place to help those with the capacity to prepare well for emergencies.

What is an emergency fund?

An emergency fund is a stash of money set aside by an individual or a family to cater for unexpected expenses and emergencies. The Business Dictionary defines it as “money which is set aside for an emergency situation, such as unexpected unemployment or injury, or a natural disaster which destroys one’s home and belongings.” According to Investopedia, it is “a source of ready cash in case of an unplanned expense, an illness.”

There are three basic features of an emergency fund:

• Self-funded insurance: When you purchase insurance, you pay a monthly premium so that the insurer can indemnify you in the event of a loss(es). An emergency fund is self-funded insurance. You are both the insured and the insurer. You set aside a stash of money out of your regular income to indemnify yourself when the occasion for which you set the money aside arises. 
• Takes care of emergencies: An emergency fund, as its name implies, is meant to take care of your emergencies. Emergencies can include unexpected expenses like unexpected motor vehicle repairs, travel and medical cost, unexpected situations like job loss or poor returns from a business, and disastrous situations like pandemics and other natural disasters that affect your ability to earn income or increase your expenses.
• Ready cash: An emergency fund is not primarily an investment. The purpose is not to generate as many returns as possible but to have a readily available stash of cash when emergencies hit. The focus is liquidity.

The case for an emergency fund

When there is an emergency, there are two popular ways people deal with them: debt and asset (investment) liquidation.

For people without many investments, their first recourse in emergencies is to borrow money. While payday loans and other types of consumer loans are now very accessible (thanks to fintech), the cost of obtaining these loans is still high.

For example, Fair Money, a consumer lending app, charges 10-30% interest for consumer loans, depending on the customer’s profile and history. Palm Credit’s ranges from 14%-24%. Branch, another consumer lending app, has an interest rate ranging from 13% to 29%.

So when you use debt to cater to emergencies, you pay interest and increase your tolerance for borrowing, which can be bad for your finances going forward.

The second option is to liquidate your investments. The problem with this is that your investment might be on an upward trajectory when the emergency hits. So instead of riding with the wave, you drop off. Worse still, the market may be down, forcing you to sell your investments at a loss. In investing, time in the market is more important than timing the market; when emergencies force you off the market, there is an opportunity cost.

What’s the solution? Emergency Funds.

As said above, an emergency fund is self-funded insurance – it is your money. You don’t pay any interest to use your emergency funds; neither do you lose time in the market. On the contrary, your emergency fund would have earned some interest during the days there were no emergencies.

Starting an emergency fund

The size of your emergency fund

Experts suggest that your emergency fund should hold three to six months of your living expenses. Your living expenses is how much you need to take care of your basic needs. The focus is on basic needs because emergencies are not the time to go on a vacation or buy your favourite video game (wants).

One way to understand this is to look at the 50:30:20 budgeting system popularized by Elizabeth Warren. In this system, 50% of your monthly income goes to basic needs (think housing –rent or mortgage, food, and clothing), 30% to wants (eating out, movies, sporting events, etc.), and 20% for savings (investments).

An emergency fund focuses on basic needs or living expenses. So experts advise you should have three to six months’ worth of your living expenses in an emergency fund. (If you don’t know your living expenses, you need to start by learning how to create a budget).

So which should you choose, three, four, or six?

• Here are certain factors to consider:
• Job stability: If your job or industry is known for instability, you are probably better off at the higher end (six months) compared to someone with a stable job in a stable industry.
• Frictional unemployment: How long does it take to get a new job after a job loss in your locale and industry? The higher the number, the more money you need in an emergency fund.
• Health insurance: If you don’t have health insurance, you should have six months of your living expenses in an emergency fund.
• Source of income: A freelancer, consultant, or small business owner with undefined income should have more money in an emergency fund than a salary earner, ceteris paribus.  
• Marital status: If you are married and your wife/husband is working, your emergency fund might not be as large as the single person (especially one with dependent relatives).
• Dependent relatives: The more people depend on your income, the larger your emergency fund should be.
• Debt: Start with a smaller emergency fund and pay off your debt before augmenting your emergency fund. Locking money away in an emergency fund while your high-interest debt lingers (especially credit card debt) is bad “business.”

Why should your emergency fund hold three to six months’ worth of your living expenses rather than total income? Since an emergency fund is a stash of money you save now for later, it is better not to over save. Why? Remember, time in the market is important. You want to have as much money in your investment accounts as soon as possible.

Let’s take Mr. A, who earns #200,000 every month. Suppose he spends #100,000 on needs, #60,000 on wants, and invests #40,000.

Suppose he chooses to have three months’ worth of his income in emergency funds; he would need #600,000. If he chose living expenses, he would need #300,000.

What will he do with the extra #300,000 (the amount above his living expenses) in case of a job loss, to take the extreme example? He will spend it on wants and investment (since his living expenses are already capped at 50%). But why go on vacations and eat out when you have lost a job, especially when you could invest that money now? Why invest many months later when an emergency hits (the 20%) when you can invest now and spend more time in the market?

So to avoid under-investing and over-saving, it’s best to stick with living expenses or, at worst, living expenses plus wants.  

How to save money for your emergency fund

The first thing is to determine how much you need in the fund. Mr. A in the example above needs #300,000 in his emergency fund.

Next is to determine how to get that money. If you follow the 50:30:20 budgeting system, you can start by committing that 20% of your income to building your emergency funds. Mr. A will need 7.5 months to build up his emergency fund.

Again, you should aggressively build your emergency fund only if you don’t have any ongoing debt that incurs interest on the outstanding balance. If you do have debt like that, you should build your emergency funds to a level (maybe 50%), take a pause, and attack the debt.

Why should you not use everything (all the 20%) for debt? Because if an emergency arises while you are paying off debts, you will only incur more debt (and the cycle continues). So while tackling debt, build your emergency level along till it reaches some comfortable level.

Why should you not use everything for emergency funds? Whatever interest the money in your emergency fund earns will always be less than the interest you incur on those types of debt.

So for balance, you can commit 10% to debt and 10% to emergency funds.

But if you are free from those types of debt, focus on building your emergency funds to the full (100%) before investing (say in stocks, mutual funds, ETFs, or cryptos). Why? If an emergency hits while you are investing, you will have to sell your investments at a loss or lose the market's positive wave.

Consider your situation and act accordingly.

Suppose Mr. A does not have debt; he should have a fully-funded emergency fund in 7.5 months, after which he can start investing.

Where to save your emergency fund

Again, the purpose of the emergency fund is not to maximize your interest but to have a liquid, easily accessible stash of cash in emergencies.

It’s not wrong to consider the interest rate, but it’s not primary. An account that earns less interest but is more accessible is better. But if you can find a good mix of both - highly accessible with high returns - why not?

What are your options?

·    Traditional savings account: You can open a savings account with your bank and deposit your emergency funds there. To avoid spending that money on non-emergencies, it’s good if you don’t request a debit card. When you need the money (for a real emergency), you can transfer the funds to your main savings account with the bank’s app or USSD code. 

In choosing a bank, you can consider the one with the highest interest rate on savings accounts.  

·     Money Market deposit accounts: They are similar to savings accounts but with higher interest rates and a minimum deposit requirement. If your emergency fund is more than the minimum deposit required, it’s a good option. Access Bank and UBA have this option.

·     Money Market mutual funds:  Money Market mutual funds earn higher interest, but they are not as liquid, generally speaking, as savings accounts or money market deposit accounts.  For example, Investment One’s Abacus fund has a two working days window before you can complete a withdrawal.

        Fintech saving and investment apps: Piggyvest’s Flex Naira is a good source for emergency funds. You can withdraw at any time while earning 8% interest per annum. Carbon’s Flex Save also allows users to save spare cash while earning 8% per annum for the “unlocked savings plan” (which allows you to withdraw anytime).

What should you do with your emergency funds?

Use the money in your emergency fund for emergencies only. Don’t withdraw money from it to buy an expensive shoe or human hair (fill in the gap). The fact that Apple has released another iPhone is not an emergency.

Don’t spend your money on non-emergencies and then become stranded when real emergencies arise.

Make your emergency fund a revolving account - replace what you spend. Ensure that your emergency fund is always at 100%. When you spend money from it on an emergency, start replacing it once the emergency dissipates.

Conclusion

Man plans, but God disposes. Since we don’t control the future, the only option we have is to prepare. COVID-19 should have taught us the importance of preparing for uncertain times.

One way we can do that financially is to start and keep an emergency fund to avoid taking up debt or liquidating our investments. Prepare your budget, save for emergencies, and be ready for the uncertain future.