What is an emergency fund?

The emergency fund is an amount that is kept aside to meet financial emergencies such as medical expenses and debt settlements. Emergency funds reduce the burden on people during their hardships. People save small portions of their earnings or paychecks as emergency funds to meet financial emergencies. Emergency funds should be saved or invested in such a way that they must be easily liquidated during emergencies. The main purpose of an emergency fund is its availability when required.

Why an emergency fund is important?

An emergency fund must be one of the financial goals for every individual. Emergency funds help people when they need financial support. An emergency fund is very important during the unpredictable challenges of the future such as unemployment, health issues, and other necessities. The following are the importance of an emergency fund:

To meet financial needs

The emergency fund will help people in their financial crisis which can occur due to some unexpected expenses like car repair, home maintenance, and medical expenses. It acts as a safety net during such emergencies. People can avoid last-minute hassles with the availability of emergency funds.

Extends help in unemployment period

When people lose their jobs and are searching for another job, they might suffer from adverse financial conditions. An emergency fund will provide financial support to people during such times. Emergency savings can be utilized to cover their expenses at the time of such hardships.

Helps to manage medical expenses

Medical and hospital expenses arise because of unexpected health issues. If people have emergency savings, it will be useful for them to meet their medical expenses, hospital expenses, and other related expenses without any tension. People can withdraw and utilize emergency funds for medical expenses.

Protects from debts

An emergency fund helps people to settle their debts. Credit card payments and other borrowings are useful to settle debts and loans, but they will charge a higher rate of interest from borrowers. Thus, emergency savings are considered more important than credit cards and other borrowings.

Categories of emergency funds

Emergency funds are classified into long-term emergency funds and short-term emergency funds.

Long-term emergency funds

In this category, people shall invest for natural calamities and disasters which do not occur often. In long-term emergency funds, people can gain low-risk interest for a long period. Long-term emergency funds will delay for two days or more to receive the amount.

Short-term emergency funds

In this category, people shall invest for emergency situations like medical expenses and debts. Short-term emergency funds provide low-interest rates, but they provide instant accessibility. People can withdraw short-term emergency funds without any delay.

Prerequisites of creating an emergency fund

When creating an emergency fund, people must ensure the liquidity of an emergency fund and interest returns on the emergency funds. There are a lot of financial institutions and banks accepting deposits from the public. Before investing with these institutions and investment companies, people should analyze the rate of return of investments and their liquidity. People should invest in high-return investment schemes to yield high-interest income on their investments.

Where to invest an emergency fund?

People need to invest their money in safer and higher return investment schemes. Banks and financial institutions provide various emergency fund savings schemes with various maturity periods and various return rates. Investors should choose where to invest and the form of investment. The following are some forms of emergency funds:

Savings accounts

People can save their cash with savings bank accounts which provide moderate-interest income but provide easy accessibility to the funds. The amount deposited in the bank can be drawn at any time, at any place through ATM cards. Banks offer various interest rates and different interest payment periods such as monthly, quarterly, half-yearly, and annually. Interest is calculated on the outstanding amount at the time of interest payment.

Money market accounts

Money market accounts are similar to savings accounts. But a money market account provides a higher-yield rate than a savings account. Money market accounts provide benefits such as debit cards and cheque writing facilities. It is a deposit account that pays interest on people’s deposits based on market interest rates. Banks and credit unions are providing money market account facilities.

Certificate of Deposits (CD)

A certificate of deposit is a deposit account that requires a lump-sum deposit amount at the time of opening a deposit account. CD provides a fixed maturity period and fixed interest rate. CD provides higher interest income than savings accounts and money market accounts. It is the best option to earn higher interest. The depositor or investor is liable to pay penalties if the CDs are withdrawn before. CD accounts can be opened with banks and financial institutions.

Roth IRA (Individual Retirement Account)

Roth IRA is an emergency fund account that provides tax advantages subject to certain conditions. Roth IRA removes tax penalties at the time of withdrawal because while investing in Roth IRA, investors are required to pay tax. It is a type of emergency fund which is maintained until the retirement time of workers.

Online savings account

Online savings accounts are FDIC (Federal Deposit Insurance Corporation)-insured and giving a high-yield than brick-and-mortar accounts. People can open these accounts with banks and other financial institutions like a normal savings account. Online savings accounts are highly flexible and reduce time consumption.

Investment in bonds and stocks

Investing in bonds and stocks provides a higher yield and offers higher maturity periods. But investments in bonds and securities provide lower liquidity. Redemption of bonds and securities before the maturity period may have the risk of loss.

Amount of emergency fund to be created

People are required to keep an emergency fund to cover their expenses during financial hardships. People need not be expected to save a high amount. They should save money which is equal to covering a minimum of three to six-month expenses. After deducting all the monthly expenses from the monthly paycheck or earnings of people, a small portion of the balance amount can be invested as an emergency fund.

Context and Applications

This topic is significant in general studies, professional exams, and also for both undergraduate and postgraduate courses, especially for

• Bachelors in Business Administration (Finance)
• Masters in Business Administration (Finance)
• Masters in Business Administration (Investment Management)

Practice Problems

Question 1: Which one is not the category of an emergency fund?

   a) Short-term emergency funds

   b) Long-term emergency funds

   c) Fixed emergency funds

   d) None of the above

Answer: Option (c)

Explanation: Emergency funds are categorized into long-term and short-term emergency funds. Long-term emergency funds are created for natural calamities. Short-term emergency funds are created for immediate requirements like medical expenses.

Question 2: What needs to consider while investing in emergency funds?

a) Maturity period

b) Liquidity

c) Credit card payments

d) All of the above

Answer: Option (b)

Explanation: Before starting to invest, people should ensure that an emergency fund is liquid in nature. Then only people can withdraw emergency funds during financial emergencies.

Question 3: What are the forms of an emergency fund?

a) Savings account

b) Money market account

c) Certificate of Deposits

d) All of the above

Answer: Option (d)

Explanation: Savings account, money market account, Certificate of Deposits, Roth IRA, and investment in bonds and securities are some forms of the emergency fund.

Question 4: Which emergency fund investment gives a high rate of return?

a) Roth IRA

b) Money market account

c) Certificate of Deposits

d) Savings account

Answer: Option (c)

Explanation: Certificate of Deposits provides higher interest income than savings accounts and money market accounts. It is the best option to earn higher interest.

Question 5: Which emergency fund account provides debit card and cheque writing facilities?

a) Money market account

b) Certificate of Deposits

c) Roth IRA

d) None of the above

Answer: Option (a)

Explanation: Money market accounts have some other features like debit cards and cheque writing facilities. A money market account is similar to a savings account, but it provides a higher return on deposits than a savings account.