Emergency Fund: What Is It, and Do You Need One?

Paul Atherton |
07-09-2021
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If you’ve ever had an unexpected cost and weren’t sure how to pay it, an emergency fund might be your next financial step.

Wondering what an emergency fund is? Well, the clue is in the name. The whole point is to set up a dedicated fund for an emergency.

If you don’t already have an emergency fund, you aren’t alone. Most people don’t tend to plan for emergencies; we go with the flow. But the reality is, you really should set yourself up with a fund for unexpected events.

Why do you need an emergency fund?

These funds are vital for your financial and psychological wellbeing. They are there for those circumstances you didn’t plan to happen, like events that will disrupt your cash flow, finances, or personal life.

Here are a few examples: the boiler blows up. Your car breaks down. Your dog eats a tennis ball.

For some people, emergency events may not even be this extreme. It could just be a bill that’s higher than you expected.

Your fund is there for anything that poses enough of a financial problem for you that you wouldn’t know where to get the money.

The more dramatic version would be, what if you lose your job?

You’re out of work, and you don’t know when your next job will come along. What if it’s many months away?

After COVID, the possibility of job loss might be a lot more real for many people.

There’s another excellent reason to have an emergency fund.

Once they start building up their fund, every person I know has felt a tremendous sense of relief. They know they’ve got something there that will be there for that rainy day. And we all know those rainy days happen.

That relief can be tremendous. You start walking around realising, oh my God, I was having this low level of constant stress around me all this time. You usually don’t notice that stress until it’s relieved.

How do you start an emergency fund?

When I talk to my clients, the most crucial aspect we start with is working out how they can save for their fund.

The first question asked is, well, how much? How much do I need in my emergency fund?

Generally, my answer is “something is better than nothing”.

But I like to start with a minimum of three months of a living salary. So, the amount you could live off for three months.

Come up with that budget. Work out how much you live off for each month.

Now, you need three months of that.

Most people can get themselves sorted out within three months. Whether that’s finding a new source of income or making budget adjustments, most people can get it done in three months.

If you only have a month to do it? That’s a lot tighter and will bring you a lot more stress. That’s why for the average person, three months’ worth of expenses in their emergency fund is the goal.

Over 50% of people have less than one week worth of cash in their account. A lot just have nothing. Or worse, they just have debt. Starting with a small fund isn’t ideal, but it still means you will be better off than 50% of other people.

So, three months is a minimum. Personally, I like to have a year.

That’s my paranoia.

I like to think, if I need to, I can take a year off. Knowing that I could go for an entire year without an income is incredibly freeing.

How do you manage your fund? Should you invest?

This money doesn’t have to be invested. In fact, I would suggest you don’t invest it.

An emergency fund is more of a cash instrument. It should be very liquid. You need to be able to access it almost instantly.

I have a four-step process for managing your emergency fund.

1.   Know the amount.

That’s your three months of expenses. Calculate that and make it your initial goal.

You should also periodically check on your account and take note of how much money is in there.

2.   Set up a separate account.

If you only have one account for all your finances, you really don’t have that emergency fund saved.

There’s nothing that makes it hard for you to get that money.

So, make your emergency fund completely separate. You can go with another institution entirely. At the very least, it needs to be a different account from your primary income and expenses.

Everything’s electronic, so you can transfer money quickly when you need the money, but having to transfer it will give you a psychological barrier that may stop you from spending it when you don’t need to.

3.   Set up an automatic process to build your balance.

You need a process to build up your fund. It doesn’t build itself.

Here, automation is your friend. You can have money automatically paid out of your account.

Just think of it as a tax. Taxes are life. You just deal with it.

Just put a tax on yourself. The great news is the tax will go to fund yourself instead of someone else.

You can (and should) start small. Just set aside enough that you don’t feel much of an impact, then you can get comfortable with it. Once you’re comfortable, you can ratchet it up over time.

Automation is a powerful tool.

4.   Level up.

What does that mean?

You started small, but perhaps now it’s not viable for you to increase the amount you transfer from your income.

Well, where can you get more money?

People can be creative. Maybe you’ve got some stuff lying around the house that you can sell. Start a side business. Put that money into your emergency account.

And don’t forget the importance of compounding.

Again, you won’t believe the positive aspect having an emergency fund will have on your mental wellbeing.

When setting yourself up for emergencies, remember…

  1. Emergency funds are vital for your financial and psychological wellbeing—knowing that you have cash for emergencies lowers your everyday stress.
  2. Start by setting a goal of three months’ worth of expenses for your fund—you can increase this later.
  3. Put the money into a separate account—even a different bank works if find one with great interest rates.
  4. Automatically pay from your income into your fund—sending the money before you even see it means you won’t miss it as much.
  5. Come up with some creative ways to add extra money to your fund—clean up your house and sell some junk, for instance.

Get more tips for your financial freedom by signing up to my newsletter below.

 

This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.

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An ex-Wall Street advisor who worked with major players in the global financial industry for over 30 years, Paul’s mission is to help regular people reclaim their wealth and financial security.

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