Emergency Fund – Why You Need One

Setting up an emergency fund is the first and most important step in securing any financial position. If you build a new house and don’t get the foundations right, a bit of a shift in the ground could completely ruin your expensive bespoke kitchen. Emergency funds are the foundations for your finances. Whether you have a fairly simple financial situation or you are a sophisticated investor, an emergency fund is critical.

An emergency fund is….

A place where you can access cash within a short space of time without significant penalties, usually separated from your day to day finances. It’s to cover yourself for unexpectedly large (and mandatory) expenses. Imagine your car broke down and needed a new carburettor, or your hot water service broke and needed to be replaced, or your employer unexpectedly went into liquidation and stopped paying your salary?

An emergency fund allows you to cope with these expenses without having to get into dangerous and expensive forms of debt. Ideally you want to separate it physically and intellectually from your day to day expenses, because an emergency fund is no good if you regularly dip into it and find that it’s gone when you really need it. So it’s probably worth pointing out that it’s not a good place to save for a holiday, tempting thought that might be!

How big should my emergency fund be?

How much you should have in an emergency fund varies from person to person. A general rule of thumb is three months’ salary. Some people will need more than this. People who have large debts or financial commitments, financial dependents, are self-employed, contract or casual workers, or whose personal circumstances are going through significant change (such as divorce or health problems) are advised to keep a larger pool of funds available.

Where do you keep your emergency funds?

One obvious answer is to keep your emergency funds in a high interest online bank account. The advantage of this is that you generally don’t have ATM access, reducing the chances that you draw on the funds in a moment of weakness such as Friday night drinks or an amazing bargain at the stocktake sales. Getting a better rate of interest than a standard savings account makes your money work that little bit harder for you. Term deposits are a similar option, getting you a higher level of return but bear in mind that they can take a little bit more work to break if you need the account and you can lose a fair amount of the interest you have earned if you have to access it before the maturity date.

Another option may be excess capacity on a mortgage. The interest you pay on your home loan is greater than the interest you earn in a bank account (particularly when you look at impact of tax). One option is to make additional repayments which can be redrawn if necessary. It is wise to check whether you pay any fees to redraw, whether you need the banks approval and how long redraw takes. Another option, often more prudent, is to set up an offset facility on your loan. An offset works like a bank account but instead of paying you interest on the bank account it will calculate savings to the interest on your home loan. A word of caution for those who have interest only loans, these are very flexible loans and can house your emergency cash, but it is very easy to spend more than you thought and end up having spent your emergency fund on your day-to-day expenses.

Emergency funds gives you more opportunities

If you have a strong emergency fund you are in a much more secure position to cope with the ups and downs of investing in a share fund or investment property. An emergency fund may allow you to increase the excess on your home and contents insurance, potentially saving hundreds of dollars a year. Or give you the opportunity to make more satisfying and financially rewarding career choices by holding out for the right job rather than the first one the comes along.

 

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