What is an Emergency Fund?
An Emergency Fund in simple terms is a lump of money that you keep aside to use in case of emergencies. It is a “peace of mind” account. It is money you put away for a “rainy day”. It gives you the comfort to know that is something drastic happens and all of a sudden you need a sum of money it is sitting there waiting. Unfortunately life does throw curve balls every now and then and an emergency fund can help smooth those out, at least financially.
What constitutes an emergency?
Obviously this is subjective but generally I would say anything that falls outside of your expected spending could be considered an emergency. You should be budgeting for all your regular expenses through out the years as well as “known” expenses such as birthdays and Christmas, these should not be surprises. Below are some things I would consider financial emergencies:
- Large medical expense not covered by insurance.
- Unexpected pet bill, e.g. dog escapes and gets hit by a car.
- Washing machine or hot water system suddenly goes.
- Travel expenses for visiting sick relative or friend.
- Car Engine failure.
- Loss of job.
These are all things you cannot plan for and would need immediate access to a large sum of cash. Of course there are many others and everyone will have a slightly different take but this gives you an idea.
Where to keep the cash?
Generally you want to keep this in a separate bank account to your normal day to day spending so you don’t feel tempted to use it for something other else (like a holiday perhaps!). Some people like to keep it in a separate bank all together (Scott Pape certainly does in his excellent book The Barefoot Investor. Personally since I have a mortgage I like to keep mine a offset account as there are no high interest bank account that can match the interest I will save.
What I wouldn’t recommend is holding it as physical cash as you are simply losing money in doing so, you need to put every dollar to work.
I also wouldn’t recommend putting it into an investment fund, even a stable one like an LIC (Listed Investment Company) or ETF (Exchange Traded Fund) as not only do you increase your risk of losing money in the short term but typically it can take a few days to get the cash out.
How much do I need?
Of course this is personal and will certainly differ from person to person however as a general guide I would aim to make it at least a month of your income, to begin with, and then aim to save up to 6 months of your income. Alternatively go by gut feel, if you feel comfortable with $1000, $2000, $5000 or even $50,000 run with that, it really is whatever makes you feel comfortable. Knowing you have some cash sitting aside will have a great effect on your overall well being, trust me!
So there you go, a quick rundown of what an emergency fund is and how you should treat it.
Just a quick remainder that I am not a financial adviser and the information in this article is provided for entertainment purposes only and should not be taken as personal financial advice.