An emergency fund is money squirrelled away specifically for an unexpected expense or hit to your finances. These unexpected expenses could be the result of job loss, illness, or unexpected repairs to or replacement of your possessions.
The standard advice is to put aside an amount of money (anywhere from $1,000 upwards) into a savings account to which you have ready access. That way when emergencies crop up, you have the cash available to deal with them. You can read more about saving for an emergency fund here.
There is a more novel (and more sensible, I think) approach to building an emergency fund that I first read about on the Frugal Dad blog. Frugal Dad suggests a three-tiered approach to building and keeping an emergency fund that in light of several recent events, I have adopted with a slight addendum.
In short, the idea is to break up your emergency fund into three parts: a small stash of cash kept at home for immediate emergencies, a larger amount kept in your everyday bank account where you have ready access to it, and the third level of emergency fund kept in a high-interest savings account that is earning you a small income rather than just sitting around earning you nothing.
There is, I would argue, a fourth level to your emergency fund that includes adequate insurance, long-term investments and paying extra towards your mortgage. While these things aren’t quite the same as stashing away ready cash, they do provide a buffer against emergencies.
Emergencies happen to us all. An emergency fund provides a vital buffer against the financial damage they can cause. A four-tiered emergency fund leaves you prepared while also making the most of your finances.
1. A stash of Cash Emergency Fund
When it comes to stashing cash around the house, I’m not suggesting you keep thousands of dollars hidden in jars in your panty, I’m talking $100 – $300 set aside for cash emergencies. What kind of cash emergencies? Here are just a few scenarios:
- You can’t get to the bank or ATM because of a natural disaster. Floods, fires, earthquakes, cyclones, snowstorms. We’ve seen them all in the last couple of months.
- There are widespread power outages. How will you buy ‘milk and bread’ if ATMs and EFTPOS machines are not working?
- Your bank makes a mistake. The recent Nation Australia Bank computer ‘glitch’ left many customers without money for days. However, this kind of computer glitch happens to individuals all the time. A stash of cash provides a buffer against such glitches while they are being fixed.
- The tradesman who has just fixed your broken hot water system only takes cash or offers you a significant cash-in-hand discount (yes, I know it’s not legal, but it happens anyway).
Keep your stash well hidden but easily accessible (by you, that is). It may also be a good idea to keep it in a sealable plastic bag along with copies of important documents for protection.
2. Ready Access Emergency Fund
The next level of your emergency fund is cash saved in an everyday bank account that you have easy access to. I would suggest that (depending on the fees your bank charges) it is better to keep this amount separate from the everyday bank account that you use for your household expenses.
The standard advice is to keep $1,000 in this account, but obviously, the amount you keep will be dependent on your own circumstances. The reason for using an everyday account as opposed to a high-interest account is accessibility, often high-interest accounts are internet only or you have to transfer funds to access them, or they don’t come with an EFTPOS card.
3. An emergency fund that is working for you
The third level of your emergency fund is money saved in a high-interest bank account. How much you save will depend on your circumstance. Again, the ‘standard’ advice is to save 6 months worth of income, but I admit that we don’t have anything near that saved nor intend to at the moment.
This level of your emergency fund is where accessibility takes a small step backward to allow you to earn some income on your savings rather than have them earn nothing.
4. Advanced emergency fund
On top of keeping cash in the above three ways, assets that are quickly converted to cash, such as shares, can also be used in times of emergency. While these might not specifically form part of your emergency fund, you can rest assured that if you need money tomorrow, you have backup funds available while still earning income and potential capital gains on your savings.
Being adequately insured also provides a buffer against possible emergencies. Adequate insurances means valuing your possessions correctly so that you are not under-insured and getting the right coverage for your circumstances. If you are a single income family, you may decide to investigate income-protection insurance. Your financial advisor should be able to give you advice on what insurance is best for you.
Making extra repayments on your mortgage now means that you have cash available to redraw (assuming you have this facility on your mortgage) in times of emergency. If you’re faced with the prospect of losing your home because you cannot pay the mortgage, having several months or even years worth of extra repayments that you can redraw allows you to keep paying your mortgage until you get back on your feet. It would be a last resort option, but one that could help out during a period of unexpected unemployment, for example.
Last of all, under very specific circumstances of financial hardship, you can apply to the government to access part of your superannuation to help meet your costs.