Why you need an emergency fund

What is an emergency fund?

An emergency fund is money saved and put aside to meet unexpected expenses, such as future medical bills or unforeseen home and car repairs, or to cover a period of unemployment. 

It should comprise mostly cash or other highly-liquid assets that you can access quickly in an emergency. This means you should refrain from investing your emergency savings in assets that can take a long time to sell, such as property or highly volatile shares, as the fluctuations in share prices may lead to you having to sell at a loss to access your money.

Think of an emergency fund almost like insurance. You set aside a portion of your monthly salary as a premium, and the fund pays out if you encounter financial hardship. An emergency fund can enable you to rest easy, knowing that you already have the money available to deal with any unexpected curveball.

The ideal size of an emergency fund can vary. Financial advisors recommend enough to cover three to six months' worth of living expenses. However, the economic uncertainty caused by the COVID-19 pandemic has encouraged more conservative recommendations of up to 12 months' worth. Ultimately, you should tailor the size of your emergency fund to your unique financial circumstances.

Why you need an emergency fund

Almost all of us will face periods of financial hardship at some point. Whether it's due to the loss of a job, an unforeseen injury or illness, or damage to our home or car, financial emergencies can come along and seriously upend our lives. An emergency fund can help relieve some of these financial stresses.

Knowing that you have money already set aside to meet these challenges can give you great peace of mind. A decent emergency fund also means you won't have to rely on personal loans or credit cards to cover unanticipated expenses. 

These sources of short-term funding can involve high interest rates, and the last thing you want to worry about in a crisis is racking up expensive debt.

How can an emergency fund help in volatile times?

You might be sweating during heightened volatility if you have a high proportion of wealth invested in the share market. This is to be expected. When the size of your wealth is tied to the vagaries of the share market, it's only natural to feel nervous when prices yo-yo daily. 

If the market goes south, you might worry about coping if a significant expense arose and you had to sell some of your shares quickly – potentially at a loss.

However, if you already have a financial safety net, you don't need to worry so much about short-term volatility in the share market. You can relax knowing that, even if money gets tight, you won't be forced to sell your shares at a time when the market might be down.

This also illustrates why you shouldn't invest your emergency fund in risky assets. You should always consider your share portfolio a long-term investment – it will grow over time with patience and discipline. 

But, because the value of your portfolio can vary quite a lot from day to day, it's not always wise to think you can use it to cover any surprise short-term expenses. Almost by nature, these expenses always seem to pop up at precisely the worst possible moments! Setting up an emergency fund – separate from your main share portfolio – is the best way to ensure you can cover these costs.

Having some cash as part of your emergency fund reduces your reliance on the share market and means you won't feel quite as anxious during a market correction.

How much should your safety net be worth?

The appropriate size for your emergency fund depends on your circumstances. Ask five financial advisors, and they'll probably give you five different answers. 

Your emergency fund should be tailored to your circumstances and unique financial needs. For example, a single parent with a home loan might need a larger emergency fund than a university student who still lives at home. 

You may naturally be more risk-averse and require a larger emergency fund to feel financially stable. It's entirely up to you and what makes you feel most comfortable and secure.

It's a good idea to spend some time monitoring your daily expenses and thinking about how much of a safety net you might need to feel financially supported during an emergency. You must factor in your dependents and their particular financial needs if you have a family. 

List any significant expenses you know are lurking on the horizon, and think about how much additional cash you might need to save to cover them if you find yourself in a financial squeeze. For example, if you were to lose your job suddenly.

Also, keep in mind that the ideal size of your emergency fund may shift over time. A significant change to your circumstances – a new baby, for instance – may drastically change the amount of savings you might need to feel financially secure. Review the amount in your emergency fund periodically to see if you think it is still enough to cover you in a financial emergency. 

How to create an emergency fund

Once you've decided on a suitable size for your emergency fund, it's unlikely that you'll be able to set aside all that money straight away in one go. An emergency fund typically comprises money you save up over time.

Think of the amount as a goal you can work toward. See if you can identify a fraction of your salary that you can put towards your emergency fund. No amount is too small to get started. If you have some unnecessary expenses, see if you can cut them down to funnel some extra money into your emergency fund each week.

Many financial advisors also recommend that if you have any windfalls – like a tax refund or a pay bonus – you set all or part of this money aside in your emergency fund. This can help you reach your savings goals faster. 

Remember, the more money you put away, the sooner you'll be able to rest easy, knowing you have the cash available to meet whatever financial challenges the world throws at you.

Steps in building an emergency fund

1. Set a financial goal

First, work out how much money you want to hold in your emergency savings account. As we've discussed, this is often down to personal preference but should probably be enough to support you if you are out of a job for six to 12 months.

If you are still trying to figure out how much you should save, you can always speak to a financial advisor. Some financial websites also have an emergency fund calculator that you can use to set a financial goal.

2. Save, save, save!

The most important step in building an emergency fund is setting a regular savings goal. Look at your weekly or monthly expenses and your after-tax salary, and identify an amount you can afford to set aside from each pay cheque. Try to eliminate your outstanding debts before getting started, as interest repayments can eat into the amount you can save.

3. Maintain

If you have to dip into your emergency fund to cover unexpected expenses, replenish your account. You want to maintain the balance of your emergency fund at the target amount you identified in step one.

4. Monitor

If your personal circumstances suddenly change – maybe you start a family or buy a house – it could impact the amount of money you need in your emergency fund. So, take a moment now and then to reassess your financial situation and see if you might need a little extra in your emergency fund. If so, start the process of saving again.

Where to keep your emergency fund?

The lower the risk, the better for your emergency fund. This means the best place to keep your emergency fund is often simply in a high-yielding savings account. That way, it's readily available when you need it. Term deposits can also be a good option, but you may be penalised if you need to withdraw funds early.

Some investors may choose to invest some of their emergency funds in shares, but this also leaves you open to losses if you need your money in a hurry when the market is down. If you choose to invest some of your emergency funds in stocks, ensure they are low-risk blue chips, low-volatility exchange-traded funds (ETFs), or other similarly stable investments.

When to use it 

Your emergency fund should only be used to cover unexpected or sudden expenses. It's your safety net to support you if you are in a spot of financial trouble. Some good examples of when to use your emergency fund are for car or home repairs, unexpected medical bills, or the loss of your job.

Ultimately, when you choose to use your emergency fund is really up to you. However, if you're constantly dipping into it to cover your regular expenses or a night out at a restaurant, you're not using it correctly. 

If this sounds like you, then you need to revisit your savings plan. Put a little less of your pay into your emergency fund, or try to cut back on some of your costs.

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