Thanks to the extreme uncertainty that the pandemic brought for all of us in 2020, the realization that having an emergency fund is important seems to be settling in. An emergency fund is essentially money kept aside in very low risk, flexible investment options or even a separate bank account which caters to at least six months of your living expenses, or four months of income, in the event of an unforeseen situation causing loss of earnings.
While this is a priority even before you start investing, it is not a one-time affair, you need to revisit your emergency fund, at least once a year.
Keep in mind these factors while rebalancing.
1.Making provision for changes
An Emergency fund is mainly to cater for living expenses when income stops suddenly. Living expenses are not static and keep changing. If there has been a material change in your circumstances like addition of a family member or change in house rent, make sure to add these in for your future emergency funds.
2. Necessary expense vs wants
Living expenses are sometimes confused with lifestyle expenses. The latter don’t need to be accounted for even when they go up year after year. Your lifestyle expenses are what you spend on brand, entertainment and leisure travel among other things. You don’t need to keep up with these expenses in case of an earning emergency, you just stop this kind of spending. While reviewing your emergency fund for the next year, make sure you don’t add any such lifestyle expenses into the kitty.
3. Rationalise provision where you can instead insure it
If your emergency fund is structured to include medical expenses or pay for car accidents, you need to rethink that allocation. These are expenses that can be covered via insurance and there is no need for you to put aside large sums for such eventualities. Review your emergency fund to ensure that you are not over-allocating to expenses that can be covered via reasonably priced insurance plans.
An emergency fund is an important part of your financial plan and helps put in place a foundation for the other aspects of your financial life. Moving into a new calendar year is a good time to review the outline of your emergency fund and ensure that excesses are trimmed while the priority spends have sufficient room in the revised pool.