Today I am going to discuss how to build an emergency fund. I’ll cover what they are, why you should have one, how to use one and how to build one.
An emergency fund as the name suggests is a fund that you use in the event of an emergency. While the term has been used interchangeably with savings accounts in the past, the two are not necessarily the same. When you save your money, you are typically saving it with the intent of purchasing something at a later date. It could be a holiday, a house deposit, an investment amount etc.
An emergency fund, on the other hand, isn’t something you use to save up to purchase something, it is an amount of money that you accumulate to act as a safety buffer against unexpected financial hardship. Ultimately, the goal is to be able to spend your emergency budget if needed and only under that circumstance.
For example, if you chip a tooth, become unemployed, have to pay collateral damage after a car crash or any unexpected incident occurs that costs you money, that’s when you would use an emergency fund. They are buffers that are put in place to make sure that you don’t go into debt if you run into unexpected financial hardship.
For the above reasons, it is highly advantageous to have an emergency fund as it mitigates the need for you having to go into debt to cover an unexpected expense. Someone who doesn’t have an emergency fund that experiences things like unemployment or a freak accident that costs them thousands in reparation will often be forced to go into debt through credit cards or loans to stay afloat.
By resorting to these options, you can end up paying thousands in unnecessary interest fees just because you got caught off guard. With an emergency fund, on the other hand, you can afford that freak car accident, having to get your tires replaced, that expensive root canal, being unemployed for a few months and a plethora of other potential financial issues. It ultimately gives you peace of mind and offsets any potential short-term debt obligations that you may run into.
This differs from person to person, but as a rule of thumb, it is recommended that you keep anywhere from 3-12 months of your monthly living expenses in your emergency fund. Ultimately, it comes down to your risk tolerance. If you are comfortable that in the event of you losing your job that you can find employment within 3 months then perhaps that is all you need. If you come from a family where you’re the sole income earner then perhaps you would want something like 6-12 months worth of expenses saved to be an even greater buffer. If you need a hand working out how much you spend each month, here is an easy to follow guide.
The way you build an emergency fund is by living below your means. Simply put, you need to spend less money than you make. You can do this by creating a budget and sticking to it, as the more expenses you can cut down on, the more money you can afford to pay yourself.
If you’re looking for some tips and tricks on how to cut back on your expenses, I explain my savings strategies here. Once you are in a position where you are making more than you are spending, start paying yourself first each paycheck by allocating a fixed amount of money towards a high-interest savings account. Keep doing this until your emergency fund reaches a level that you are happy with.
If you build your emergency fund to a level that you are comfortable with, you can then start to save your money towards something else. Whether it be investing, a new car, a home deposit or anything that you want to purchase. Simply leave your emergency fund in a HISA that beats inflation and begin saving money in a separate account.
Remember, that your emergency fund is only for genuine emergencies and should not be used to purchase things like phone upgrades or unnecessary expenses. That’s what your savings account is for. When you tap into your emergency fund, simply reallocate the amount that you put towards your savings each week into your emergency fund until it is back to your comfortable balance. Once it is restored, you can continue saving.
Repeat this process and you will be in a position where you have a comfortable safety buffer in addition to the ability to save for things that you want without risking going into debt.
If you have already built an emergency fund and would like to invest additional income, the following resources cover popular investments in Australia: