Emergency funds: what are they, and why are they important?


An emergency fund refers to a pot of money reserved for times of financial distress. We cannot control the world around us 100% of the time. You don't know when you might lose a job. Or a world-changing incident, such as the 2020 pandemic, occurs.Β 

Building an emergency fund is sensible to maintain financial well-being during such times. The amount you save depends on your living expenses. Although, it's recommended you stash away a month's expenses or more.

An emergency fund provides a safety net should something happen to you or your family. Let's get to the following commonly asked questions:

  • Do I need an emergency fund?
  • How to start an emergency fund?
  • How much should an emergency fund be?
  • How to protect your emergency fund from inflation?
  • Should I invest my emergency fund?
  • Where to invest in an emergency fund?
  • How do I calculate my emergency fund?

Q1: Do I need an emergency fund?

The leading purpose of an emergency fund is to create a financial buffer to keep you afloat. It should save you from turning to a credit card, personal loan, or digging into your money saved for retirement.Β 

With an emergency fund at your back, you'll have peace of mind. No one can predict unexpected expenses.Β 

Job losses are just one example. You might also have house repairs, medical bills, or unpredictable travel. An emergency fund is even more critical if you have any other debts.Β 

For example, saddling yourself with emergency loans is terrible if you're already paying off student loans. It's imperative to avoid debt consolidation.Β 

There is no magic number you need to save. Just consider how much a few months of expenses would cost.

‍Important: You could also think about income protection as another way to cover your expenses if you cannot work.‍


Q2: How to start an emergency fund?‍

The key to starting an emergency fund is to begin early. Start saving today. The longer you have saved money, the more comfortable your emergency fund should be later in life.Β 

Don't worry if you're unsure if you have the spare cash to create a savings pot. There are many money saving strategies to get you started. To start with, think of it as a rainy day fund and deposit what you can.‍


Separate savings accounts‍

Firstly, you need to set up a separate online savings account. Rather than everyday accounts or transactions accounts, a high-yield savings account will have excellent interest returns. Your deposits will make money while you sleep.

You could also consider money market accounts. Use a compound interest calculator to assess where it is best to deposit your money.Β 

This bank account must be separate from your other savings accounts. It's not a rainy day fund. You don't want to dip into it for a holiday.

Make sure the account is easily accessible. You won't want to wait or pay a fee to withdraw your money in an emergency.‍


Define emergency‍

What is an emergency? Experts recommend you determine what constitutes an emergency in your eyes as this will help you from using the money set aside for other means. It's set up an emergency savings fund very well without knowing when to use it.

For example, you don't want to use it to pay off debt. Instances that might be an emergency include job loss, medical expenses, or other unexpected instances.

If you dip into your fund, ensure you top it up again afterwards. Say you take out a month's worth for an urgent house repair. Remember to put it back as soon as you can. ‍


Setting aside money‍

Finding the spare cash to set aside in an emergency fund isn't easy. You're likely already making super contributions for retirement savings. It's challenging to squirrel away more money on top of the cost of living.

Begin by using a savings goal calculator. Then, consider creating an informed budget planner that shows you exactly where your money goes once you have pondered over your finances.Β 

The best way to ensure you keep to your budget is to automate your savings. By creating an automatic transfer each month when your salary comes in, the money will disappear into your emergency fund before you even see it.

Additionally, many online banks allow you to connect your debit cards. It then rounds up each transaction and deposits the spare change into your savings account. It's a handy way of managing your finances.‍

Note: It doesn't matter how much you save each month. It could be anything from a balance transfer of $10 a month to $200 a month. Starting small is vital to creating sound money habits. ‍


Saving your tax rebate‍

One clever way to top up your emergency fund and reach your savings goals is to set aside your tax refunds.Β 

Transfer it straight into your savings account rather than treating it as extra money to spend. You have already paid the cash in income tax, and you won't miss it from your checking account.Β 

Considering tax rebates, it won't be long until your emergency fund looks healthy.‍


Cutting expenses‍

The best way to save money is to cut your expenses. And this includes everything from skipping the daily coffee purchases to clearing up your debts.Β 

For instance, a home loan is a significant drain on income. Consider refinancing to better interest rates or negotiating offset accounts.Β 

It's also worth trying to improve your financial health. With an improved credit score, if you need to take out any more loans, you should receive better rates. Contribute the reduction in loan payments to your emergency fund.‍

Note: Emergency funds are typically cash or highly liquid. You want to be able to access such a safety net easily.

‍Q3: How much should an emergency fund be?‍

The magnitude of your fund depends on your personal finance. Ask yourself these questions:
1)Β How stable is your income?
2) How expensive are your living costs?
3) Does anyone rely on you?

Ideally, you should save up to six months worth of expenses. Although, if your job is unstable, you may want to consider more.‍

Important: Seek financial advice about what's suitable for your objectives, financial situation, and lifestyle.


‍Q4: How to protect your emergency fund from inflation?‍

Online banking accounts are the safest place to stash away your emergency fund. However, the interest rates are too low to keep up with inflation.Β 

Ideally, the money you save in your emergency fund should earn between 4-5% interest a year to keep pace with inflation. According to the Reserve Bank of Australia, Australia's CPI inflation rate is 3.5%.

Currently, fixed-term deposits yield an abysmal 0.40% p.a. to 1% p.a. This means that you will lose purchasing power if you hold an emergency fund at a bank.

There are, however, alternative investments on the risk curve that do provide an ROI. For example, if you converted AUD$20,000 to USDC (a cryptocurrency stablecoin pegged to the U.S. dollar) and deposited it on BlockFi (a crypto lending platform), you could earn up to 8.75% APY.

Or, you could invest via Plenti (an Australian peer-to-peer lending platform that offers personal loans) that provides investors with up to 6.5% p.a.*

Important: It is risky to keep too much capital in cash as it devalues over time due to inflation. And, if you do invest via a P2P lending platform, please be sure to do your research as there will be risks associated with alternative investing.


Q5: Should I invest my emergency fund?

You can put your emergency fund wherever you like. However, remember that you want to access your funds quickly. Therefore, don't tie your money up in long-term investments.Β 

Consider the investment risks first. Your money is likely safer in a savings account. Yet, you'll likely receive a higher yield with investment options. There is plenty of high-liquidity, accessible investment accounts available.Β 

Important: If you're serious about investing, speak to financial advisers to ensure your money is in the best possible hands.Β 


Q6: Where to invest in an emergency fund?

The goal is to strike a balance between interest and liquidity. Most experts recommend steering clear of stocks and bonds. Because of its volatile nature, a managed fund is not the safest place for your emergency fund.

Similarly, super funds are ideal for long term investments. While they have good returns, super investment funds don't have the accessibility required.

Cash management accounts offer the flexibility of online banking but with the financial goals of managing super funds.Β 


Q7: How do I calculate my emergency fund?

Use an emergency fund calculator to work out how much you should save. Or manually assess your financial situation.

There are two main ways you can calculate your emergency fund.

  • Riskier approach: Calculate your monthly expenses and multiply it by the number of months that it could take you to get a new job (for some people, this might be three months, for others, it might be six months or longer).
  • Safe approach: Use your total monthly after-tax income and multiply it by the number of months it could take you to get a new job. Then, decide how many months you would like to have an emergency (this could be 6-12 months for some people).

Saving money for emergency funds is much the same as your retirement accounts. Indeed, you should use a savings calculator to manage both your emergency fund and grow your super.


In summary

Saving for an emergency is a healthy financial goal. The best way to begin is by getting started as soon as possible. Determine how many months of expenses you need. Speak to a financial advisor if you need.

Saving for an emergency doesn't have to interfere with your retirement planning. To help, use savings and retirement calculators to assist with your budgeting.


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Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs, or financial situation.

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