“If we fail to anticipate the unforeseen or expect the unexpected in a universe of infinite possibilities, we may find ourselves at the mercy of anyone or anything…” Fox Mulder, The X-Files (movie) 1998.
Sci-fi fan or not, Mulder has a point, and building an emergency fund is one way of anticipating and preparing for the unforeseen and unexpected.
An emergency fund is money put aside specifically for emergencies such as losing your job, unexpected repairs on the house or car or illness. It’s a rainy day fund for when (not if) things go wrong.
An emergency fund is savings on top of your regular saving such as saving for a holiday, saving for upcoming bills or saving for Christmas. It is fund that you only dip into when pre-defined emergencies occur.
Why build an emergency fund?
Emergencies can happen at any time whether we can afford them or not. An emergency fund provides a buffer against financial stress and worry when things go wrong. While traditionally an emergency fund is a buffer against unemployment, there are all sorts of emergencies that can come up: accidents, illness, necessary repairs around the house, to the car, emergency travel interstate or overseas if you live away from your family.
Planning for the unexpected gives you peace of mind. The thought of being retrenched is stressful, knowing you have a savings buffer to cover you for a few months of unemployment (knowing you can still pay the rent and feed the family) takes at least a little of the stress out of it.
Building an emergency fund helps prevent debt, interest and late fees. If the hot water heater suddenly breaks and you have to go out and buy a new one, then your emergency fund prevents you from going into debt to fund it. No debt equals no interest to pay, which means you’re not paying more for the item than you need to. An emergency fund also means no late fees on the bills because you don’t have to wait until next pay to pay them.
While the emergency fund is supposed to be strictly for emergencies, that doesn’t necessarily mean that you have to keep it in the bank (although this is the best option). Access to ready cash enables you to take advantage of opportunities when they arise. This might be as little as buying food in bulk when it is discounted to build your stockpile, or taking advantage of a market downturn and investing in shares.
Where to save?
You want your emergency fund to be as liquid as possible, so keeping it in a savings account, from which you can withdraw at any time is the easiest option. The American personal financial guru Dave Ramsay recently stated that it’s not important how much interest you earn as your emergency fund is not intended as an investment. I don’t necessarily agree. Why not be smart about your money and earn as much interest as possible? I use an online high interest account that has no fees and no withdrawal penalties. My fund is liquid, but still earning good interest.
Some argue that because of inflation, it is a wasted opportunity not investing your savings. While that may be the case, especially if you have a large emergency fund, keeping your money in the share market, means that you may be forced to withdraw it when the market is down.
A savings account is the easiest option particularly if you’re starting out. Explore other options as they suit you and do what’s best for you.
How to start?
- Spend less than you earn. The mantra of personal finance, but nevertheless, a necessity. You can’t save if you have no money left after your expenses, or you are continually chasing your own tail with debt. Use a budget to help you to save.
- Start small. Don’t think “I have to save $10,000” but “I will save $25 out of each paycheque.” Make it a realistic and manageable goal.
- Automate. Have your savings automatically deducted out of each pay, so that you don’t even see it. You don’t miss what you don’t see.
- Think of it as a bill. You have to pay bills, you have to pay yourself. You owe it to yourself to pay yourself first.
- Use tax refunds and bonuses. Give your savings a boost with tax refunds and bonuses, or at least part of them.
Some experts suggest saving as little as $1,000, others up to 3-6 months of your income. It’s really up to you, though. Everyone’s circumstances will be different. If 6 months income seems like an impossible goal (it does to me!), think of it in terms of saving a certain amount of dollars out of each paycheque (say $10 per week) and put this amount aside religiously.
I think it also makes more sense to work out how much emergency fund to save based on expenses as opposed to trying to save so many months of income. We all have a habit of spending what we earn. Much of that spending is unnecessary and can be cut back in times of hardship.
- Calculate your minimum monthly expenses. It helps if you have a budget. How much will you have to spend every month – rent, groceries, utilities, transport, insurance etc. and add a little extra to this to provide a buffer. Aim to save between 3 and 6 months worth of expenses.
- Whether your spouse works will change the amount that you have to save.
- Whether or not you are entitled to or take advantage of unemployment benefits will reduce the amount you need to save in your emergency fund. Rather than saving a month’s worth of expenses for instance, you could save the difference between your expenses and your benefits. Take into consideration that it may take a month or two between leaving your job and receiving benefits.
- Other income streams such as casual labour, part-time work, income from hobbies etc. will help stretch your emergency fund.
I usually put aside a little each week into an online account – anywhere between $5 and $100. Over the past couple of years, we’ve saved about 3 months worth of expenses (more if we get unemployment benefits). We have another month’s worth of expenses invested in an index fund.
(2012 update: We have had to dip into our emergency fund a lot lately. So glad we have it. It takes time to build it, but it also takes the financial stress and worries out of emergencies).
Do you keep an emergency fund? What is your emergency plan?