An emergency fund is a term used in the context of personal finance, emergency fund as the name suggests refers to those funds which can be used by an individual during times of emergency like loss of job, accident, health emergency, and so on. An individual should ideally keep 6 months of his or her monthly expenses as an emergency fund hence for example if your monthly expenses are $10000 then you should keep $60000 in emergency funds. In order to get a better understanding about this concept one should look at some of the advantages and disadvantages of an emergency fund –
Advantages of Emergency Fund
Acts as a Buffer or Safety Net
The first and foremost advantage of an emergency fund is that it acts as a buffer for an individual during times of crisis or emergency as although money is not everything still it can solve the majority of crises resulting in relief to individuals looking for help in times of emergency. In simple words, emergency funds provide mental peace and psychological support at the back of the mind of every human being the tension or anxiety related to money is always there and emergency fund address that anxiety pretty well.
No need for High Interest Loans
Another benefit of the emergency fund is that due to the availability of funds an individual will not have to resort to taking debt or finance on high interest rates which can break the back of any individual and an individual can recover from an emergency but he or she may not recover from the high interest repayment for a long period of time as high interest is like slow poison just like slow position kills the human being physically in the same way high interest rates kill the human financially.
Induces Saving Habit
It induces saving habits in an individual because in order to accumulate funds in an emergency fund an individual needs to save every month and avoid unnecessary expenses since it takes time to build an emergency fund this act of saving and avoiding unnecessary expenses can become a habit which in the long run can be of great help as far as individual financial security is concerned.
Disadvantages of Emergency Fund
Not Possible for All
The most significant disadvantage of an emergency fund is that all people can’t create an emergency fund as people having low income are barely able to make their day-to-day ends meet and for such people, an emergency fund is like a dream as they do not have the money for tomorrow and to expect that they will create an emergency fund is like asking a cyclist to race against an airplane.
Opportunity Cost of Capital
In the case of an emergency fund an individual has to park the funds in liquid assets like saving accounts or liquid debt funds which offer very low rate of interest thus creating emergency funds involves opportunity cost of capital in the form of foregone return which an individual would have earned if he or she had invested those funds into equity markets or other high returns assets class.
Other Alternatives
The idea of the emergency fund is to have a buffer in case of emergency but it is not the only solution or alternative as there are other alternatives also like investing your time and money in learning new skills so that in case of job loss one can join other profession or job, for health-related emergency one can buy health insurance and term insurance plans. In simple words just by creating an emergency fund one cannot relax as this is not a permanent solution but rather a temporary arrangement.
As one can see from the above pros and cons of emergency funds that having an emergency fund is purely an individual’s choice and that is the reason why if you are one of those individuals who is thinking of maintaining emergency funds should carefully read the above points and then only should take any decision as every individual’s needs and wants are different which is the reason why not all people are looking to have an emergency fund.