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

An emergency fund is essential for financial security because it helps cover unexpected expenses without relying on credit cards or loans. 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 seriously upend our lives. Having a dedicated savings fund ensures you can handle these situations without falling into debt or financial stress.

Key reasons to have an emergency fund include:

• Financial protection: Prevents the need to borrow money or use high-interest credit cards.
• Peace of mind: Knowing you have money set aside reduces stress during tough times.
• Job security cushion: Covers living expenses if you lose your job or experience a reduction in income.
• Avoiding debt: Personal loans and credit cards often come with high interest rates, making financial recovery even harder.

Knowing that you have money already set aside to meet these challenges can give you great peace of mind. A decent emergency fund means you won't have to rely on costly short-term funding, which can lead to expensive debt at the worst possible time. Without an emergency fund, even small financial setbacks can create long-term financial strain. Setting aside money for emergencies ensures that you're prepared for the unexpected and can maintain financial stability even in difficult situations.

How can an emergency fund help in volatile times?

If you have a large portion of your wealth invested in the stock market, it's natural to feel uneasy during periods of high volatility. When market prices fluctuate daily, the uncertainty can be stressful—especially if your financial security is closely tied to your investments.

One major concern is what happens if you need to cover a large, unexpected expense when the market is down. If you're forced to sell shares at a loss, it can negatively impact your long-term financial goals.

However, having a financial safety net can help ease these worries. With an emergency fund in place, you won't be pressured to sell your investments at an unfavorable time. Instead, you can:

• Stay calm during market downturns: Knowing you have accessible cash reduces stress.
• Avoid selling stocks at a loss: Market fluctuations won't force you to liquidate investments unexpectedly.
• Keep your portfolio focused on long-term growth: Your investments can grow steadily without being interrupted by short-term financial needs.

This highlights why your emergency fund should not be invested in risky assets. The stock market is best suited for long-term growth, but its short-term volatility makes it unreliable for sudden expenses. These financial surprises often seem to arise at the worst possible moments, making it even more important to have a separate emergency fund.

By keeping some cash on hand, you reduce your reliance on the market which means you won't feel quite as anxious during a market correction. No matter what happens with your investments, you'll have a reliable financial cushion to fall back on when you need it most.

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.

Want to learn more about investing?

You've come to the right place!

This article is part of Motley Fool Australia's comprehensive Investing Education series, covering everything from budgeting and saving to basic investing concepts and how much money you'll need to start.

Packed with easy-to-understand and regularly updated information, our articles contain the answers to your most frequently asked questions about share market investing.

Motley Fool's Education series is tailored for beginner and experienced investors alike and also includes helpful tools and resources, an A-Z glossary of Investing Definitions, and guides to specific topics of interest, including retirement planning, gold and property investment.

• The previous article in this section is How to manage debt
• Check out the next article, The importance of saving

FAQ

Is $30,000 a good emergency fund?

Yes, $30,000 can be a strong emergency fund, depending on your financial situation. Experts recommend having 3–6 months' worth of essential expenses saved. If your monthly expenses are around $5,000 or less, this amount should provide a good safety net. However, if you have higher costs, a larger emergency fund may be necessary.

How much cash do you keep at home?

Most experts suggest keeping a small amount of cash at home, typically between $100 and $500, for emergencies such as power outages or unexpected expenses. Too much cash at home increases security risks, so it's safer to keep larger amounts in a bank where it's insured and accessible when needed.

What is the 50/20/30 rule?

The 50/20/30 rule is a simple budgeting guideline that helps manage finances effectively. It suggests allocating 50% of your income to necessities (rent, food, bills), 20% to savings and debt repayment, and 30% to discretionary spending (entertainment, dining out, hobbies). This framework helps balance essential expenses while allowing room for savings and lifestyle choices.