Today I am going to tackle the question of emergency funds why you must have one. It is recommended as one of the first steps you should take towards financial freedom.
An emergency fund is basically your own little insurance policy to cover you when life’s unexpected emergencies come along, and they will! This could be loss of employment, a major appliance failure, vehicle expenses, family or friends in need or any number of things.
The general recommendation given for the size of anemergency Fund is 3-6 months of living expenses. The size in my opinion is something that has to be tailored to your own financial situation.
Factors to taken into consideration when determining your Emergency Fund size
- Your level of comfort / risk aversion
- Job security and ease of finding a similar paying job
- Dual or single income household
- Other income sources such as pension or investment returns
- Current debt levels
- Insurance cover – income protection, health insurance
- Investment property maintenance or other potential expenses.
- Access to other cheap money in an emergency – home equity
A common question is where to keep an EF. For me it should be somewhere that is a little hard to get to and low risk. A linked online bank account, laddered term deposits or short term low risk bond funds are popular choices. As long as you can get to the money fast enough in the event of an emergency but not fast enough to allow you to spend it on something you shouldn’t.
An EF does not necessarily need to take the form of 3 months of cash sitting in a bank account earning minimal interest. It could also be sitting in an offset account or available as a line of credit linked to your mortgage. If you are meticulous when it comes to finances you could even pay down debt that you could later draw from if required.
Some benefits of having an Emergency Fund
- Prevent you from having to sell investments in a down market.
- Not have to sell assets in a rush below value.
- Prevent you from having to take on costly debt.
- Reduced stress as you feel secure in the fact you have a buffer.
- Financial freedom to change jobs or take on a business venture.
- Take advantage of opportunities that arise.
- Reduce insurance requirements
- Gets you into the habit of saving money and spending less than you earn.
I think it is also important to keep your Emergency Fund separate from other savings and investments. I would also try not to let it get larger than the amount you determine to be right for your needs. The money in an EF is likely to be earning less than inflation due low risk and liquidity. It is better to put additional money towards paying down debt and investing.
For additional reading on the topic I would recommend visiting vanguards site.
Do you have an emergency fund? How big is it and how did you determine the size? Has an emergency fund saved your but? I would love to hear your story.