Budgeting for the unexpected
Some practical tips on how to build an emergency fund to give you peace of mind in uncertain times
We all know that savings are important. And most of us will have at some point been advised that it’s sensible to have three-to-six months of living expenses tucked away for emergencies. The purpose of that fund is to give you immediate access to cash for unexpected events like urgent medical bills, job loss, or a leaky roof. This fund should be at the top of your financial priority list and held in a savings account with no lock-in period, so it is always easily accessible. Emergency funds provide protection.
This is the generic advice on emergency funds espoused almost everywhere, but is there really a one size fits all approach? This kind of advice neglects the important nuances of individual circumstances. If you blindly follow it, you may be doing it all wrong. So how do you go about setting up an emergency fund that is right for you?
Debt vs. emergency funds
The first thing to think about is your financial priorities. Where exactly should building an emergency fund sit in relation to your debt obligations?
Let’s say you want an emergency fund of USD15,000, which you estimate will cover three months of your family’s living expenses. But you also have a current credit card balance of $10,000, of which you have only been making the minimum payments each month. That means an annual effective interest rate of 20 per cent or more.
In such a situation, if you decide to put any excess cash toward your emergency fund instead of paying down that debt, you are effectively ‘paying’ that interest rate of 20 per cent or more on your emergency fund. So, if you have $2,000 extra and use it toward the emergency fund, that’s $2,000 in extra credit card debt that you would be paying 20-plus per cent interest on. Think of this as the negative opportunity cost of holding debt.
This doesn’t mean you must be completely debt-free before starting an emergency fund. It’s all about the interest rates you are paying on debt – for instance, it would not make sense for you to expect to fully pay off your mortgage or car loan before starting an emergency fund. But for higher-interest debt, such as credit cards and personal loans, it might be more prudent to pay those off first.
The risk of foregone returns
This is the flip side of the above. Having a lot of cash in your emergency fund might give you peace of mind (and is also a sign of good financial security), but what is the opportunity cost of higher emergency savings?
The potential returns from alternative uses of your funds is the nuance here. You should think about the returns you could get if you invest the money instead. Being too conservative and overfunding your emergency account has hidden costs; in this case, that of foregone returns.
Accounting for personal circumstances
When deciding how much to put in an emergency fund, you should also consider things that can complement it and even, to some extent, replace it.
For example, if you and your family already have comprehensive medical insurance, then you wouldn’t need to set aside a large budget for emergency medical fees. In this scenario, your total fund amount would be lower.
Other sources of income may also be important. If you are the sole breadwinner in your family, then the importance of an emergency fund to cover an unexpected job loss increase. But if you are in a dual-income family, then the amount needed in an emergency fund will be less.
It is important to consider all the factors that could reduce (or increase) the amount you need in your emergency fund. Don’t just follow the generic advice — tailor it to your individual circumstances.
Three practical tips for building your emergency fund
Now that you’ve thought your circumstances through, check out our top tips on how to go on about building your emergency fund, even if you’re struggling to set aside adequate funds:
#1: Have a goal
By looking at your situation and keeping your personal considerations in mind, you should be able to come up with an emergency fund target that best suits your needs.
#2: Use automatic deductions and separate accounts
In theory, there is no difference between having your emergency funds mixed in with your other savings, or manually transferring money from your main account into your emergency account. But in practice, there is a huge difference.
Keeping a separate emergency account and making use of automatic deductions to fund it is far easier from a psychological perspective. That way, you won’t be tempted to dip into your emergency fund for other expenses. Understanding how to work with your own psychology is key to hitting many financial goals.
#3: Track your expenses
Many people groan at the prospect of keeping a budget – but this is a good thing. However, it can be easier said than done – it can be tedious, and people naturally slack off after a while. The good news is that keeping a budget for even a few months will still go a long way to helping you gauge how much you should have in, and how much you can realistically contribute to, your emergency fund.
Everyone should consider having an emergency fund – that advice is sound. But the ‘one size fits all’ model you hear so often neglects the ‘personal’ in ‘personal finance’. If you want to make sure that advice on emergency funds fits to your individual circumstances, you must first understand those circumstances.
Want advice that is both professional and personal? For help, speak to one of our trusted financial advisors.