Why you must have an emergency fund
We were taught as children that it pays to have money set aside for a rainy day.
The trouble is, it rains often. However, there is a big difference between a few light showers and a torrential downpour.
When money is tight it is not easy to first of all find the spare cash to put into an emergency fund and secondly to leave it there. Life just keeps on getting in the way.
The purpose of an emergency fund is to help you when you have a major life event, such as illness, losing your job, or a big bill you weren't expecting.
These are events that either substantially decrease your income or increase your costs for a period of time.
Your emergency fund should be enough to bridge the gap between your changed level of income and expenses until things get back to normal again.
It should help pay essential living costs such as rent, mortgage, food and power bills.
There is a rule of thumb that says you should always have access to enough money to cover three to six months' worth of expenses, but really the amount you need in your emergency fund depends on your personal circumstances and how security conscious you are.
Basically, it's about how much financial risk you are exposed to.
Things that can increase your financial risks are:
- Poor physical or mental health, which might impact on your ability to work.
- Underinsurance of your income or your assets.
- Dependent children or elderly parents.
- Close relatives living in another country who may need support.
- Poorly maintained house or car.
- A poor credit rating which affects your ability to borrow.
- Relationship difficulties which could lead to separation or divorce.
- Prevention, as they say, is always better than cure.
The risk of experiencing a sudden loss of income or an unexpected bill can be lessened by choosing the right career path, keeping your skills up to date, working for a good company, maintaining your assets, keeping yourself in good physical and mental shape and building strong relationships.
However, given that not all risk can be eliminated, you still need to have reserves to call upon.
Emergency funds need to be readily accessible so don't use them to invest in shares or other long term investments – you might find you lose money if you have to sell up at short notice.
On the other hand, if you have a mortgage or other debts, leaving money in a low interest savings account doesn't make a lot of sense.
Some banks now offer a mortgage offset arrangement where your savings account balances can be used to offset the balance of a variable interest mortgage for interest calculation purposes.
This is a great way to keep money on hand while keeping your mortgage interest payments down.
If your bank doesn't offer this, the same effect can be achieved by turning part of your mortgage into a line of credit, to be used only for savings. Simply save into the line of credit and draw the funds down again if disaster strikes.
If you have no mortgage or debts, your emergency fund can be kept in a high interest, online call account. If you lack the discipline to leave the account untouched, put your savings in a different bank than your everyday bank to keep them out of sight.
Another option is to invest in a fixed interest managed fund which could give a higher rate of return than a savings account while still being accessible.
Without an emergency fund you are much more likely to end up with short term, high interest debt when things go wrong.
Get into the habit of setting aside even just a small amount per week to avoid seeing your money disappear on interest payments.
Tell us in the comments, do you have an emergency fund set aside? How do you build it up?
Written by Liz Koh. First appeared on Stuff.co.nz.
Any advice contained in this communication is general advice only. None of the information provided is, or should be considered to be, personal financial advice.