What is an emergency fund and why is it important?

By | April 7, 2016

How to choose the size of your emergency fund - dividends down underAuthor: Mr DDU.

What is an emergency fund?

(You probably know what this is, but I’m going to break it down simply for you anyway.)

An emergency fund is money held separately that can be utilised in an emergency, such as your car breaking down or losing your job. In these situations you need a reliable safety net of money available immediately.

Why is an emergency fund important to us?

Our Emergency fund is extremely important to us; it gives us the security and peace of mind that we can deal with any problem that comes along. We can’t plan when an emergency is going to happen in our lives, if we could see the future we’d have won the lottery or bought Apple shares years ago (we wish). 

Facing the potential realistic cost of major car repairs, or losing our main stream of income, means our emergency fund needs to be able to comfortably cover those costs, as they will probably be more than $250.

If you are reading this quite a bit later than when it was posted, information in this article might not be current.

How do we choose how much to have?

We didn’t strictly have an emergency fund to begin with, though we did have some savings which was all in one account and eventually set up an account specifically for our emergency fund. We started by transferring $200 a month into this account until we had 1 month of expenses and gradually built from there (here’s an example of our monthly expenses). Expenses are a better gauge to go off than income; if we need to survive 3 months with no wage, we have to plan for our how much money we would spend not how much we were earning.
A good rule of thumb that we follow is that for every dependent you have, you should have at least that many in monthly expenses saved. Eg if you have a spouse and 3 kids, you should have at least 4 months of expenses worth of an emergency fund.

One of the hardest parts of having an emergency fund is training ourselves not to spend it, to see the money as untouchable unless it is a true emergency situation. It takes time to build the fund up again, so we have to make sure we are using the true definition of an emergency, rather than just unexpected expenses.

 

What about credit cards, loans or stocks as an emergency fund?

Some people think that they don’t need an emergency fund because they can use their credit card, get a loan or sell some of their assets. They are certainly entitled to have that approach if they want to, but for us there are several reasons why we don’t take that approach:

  • We don’t want to get into any debt (except a mortgage) in any circumstance.
  • When we are in a vulnerable state the last thing we need is to be going to a bank or loan shark – they may reject us (then we’re really screwed), but they will certainly charge us an excessive interest rate, making it even harder to pay off and get back to square one after the emergency.
  • Having an emergency fund means we earn interest instead of paying interest on a loan or credit card. We get to feel safe and secure having money for emergencies and get paid interest in the process, who doesn’t love free money?
  • Selling stocks is interesting idea, as your money is supposedly working harder whilst waiting for an emergency. But it means that when you do sell, it will still take a few days to get the money (what if you need it immediately that day?) and you might be selling stocks at a bad time, such as if the market has dipped. What if you’d lost your job in the 2008 crisis? You might have allocated 4 months of expenses in stocks, but if your stocks half like in 2008, you’ve only got 2 months, the price of stocks isn’t concrete.

The future of our emergency fund

Even though there’s only one dependent in our lives (one spouse, each other), we have 3 months of expenses set aside as an emergency fund in an online bank account earning 1.8% interest (we have 2 other bank accounts earning more interest than this). We can withdraw money from this account instantly without losing the interest earned that month.
In the medium term we would like to have up to 6 months of expenses set aside. As our family & income grow over the course of our lives, our emergency fund will gradually grow with us.

Do you have an emergency fund? How do you decide how much to set aside?

Thanks for reading this article about our investing journey Down Under.

Onwards and upwards!

15 thoughts on “What is an emergency fund and why is it important?

  1. ambertreeleaves

    Your approach sounds very familiar to what we do. Have the cash ready to go. No strings attached. That is the basic concept for me.
    After that, you can debate on how many months of expenses or income you need to have in that fund. We aim at 1 year of cash, distributed amongst the emergency fund, pro rata saving and life happens fund.

    1. Dividends Down Under Post author

      Hey ATL, thanks for commenting 🙂

      You are right, you can’t go wrong holding a nice amount of cash, it just means you’re more prepared if things go wrong. Depending on your age, family situation, job, lifestyle etc there are a huge number of different things you could say why you need $X to cover the unexpected. As long as you are prepared and aren’t worried, it’s all good.

  2. Team CF

    Hey guys,
    Seems that we are a bit more aggressive than you and AT above, as we strive for a cash equivalent of 3 months of expenses. For us emergencies are if sh*t really hits the fan (read double job loss, critical illness or dead), extra costs for accidental expenses are minor compared to those anyways. And once you have built up some wealth, that is really becomes your emergency fund (with a significantly reduced risk of selling at a loss, remember that you won’t ever have to sell all at once).

    We currently still have way too much cash, but this will be absorbed by our upcoming real estate transactions (yes, plural), moving costs and more in the coming months. the rest will all be invested in one way or the other. The loss in income if you keep too much cash on the side is most likely far greater than the monetary risk in any given year (still need to find that article again that calculated showed that 0% emergency fund was the best financially when putting your money in the American stockmarket for most scenarios in the last 30 years).

    However, it really is a personal risk based decision that you need to feel comfortable with.

    Cheers

    1. Dividends Down Under Post author

      Hey CF thanks for coming by 🙂

      At the moment we are the same as you, with 3 months of expenses. At the moment we only have one main source of income. We also have life insurance. This insurance is through the superannuation account, not part of our normal monthly expenses.

      Don’t get us wrong, this ‘3 months’ is sitting in a specific account, we have our normal transaction account (which normally has on average, one month of expenses) and normally we’d also have our ‘long term goal’ account which was being used to save for a house, but now that money has gone towards IVF (how plans change lol). We’ll do an article how we set our cash out in different accounts at some point.

      At the moment we are happy with our plans for our emergency fund of 3 months. The 6 months target is a long term goal (we’re talking a couple of years), so it will take a while to reach it. We are going to be investing very regularly (after IVF). We may adjust our emergency fund to be a dollar amount rather than a monthly amount at some stage perhaps.

      1. Team CF

        Glad to read that you guys have it all figured out and under control 🙂

  3. Investment Hunting

    Yes, I keep a large emergency fund. Too large for most, but given my history of losing it all, I know what it feels like to go through a financial disaster. I hold $25k in a savings account. This is enough to cover my expenses for many months. Even more importantly, having this money set aside helps with my mindset. I’m comfortable to invest the remainder of my money because I know I’m covered in an emergency.

    1. Dividends Down Under Post author

      Hey IH, thanks for your comment 🙂

      I don’t think there’s anything wrong with having that amount sitting there at all times. It’s what helps you sleep easy at night and, like you said, gives you the freedom to invest the rest – giving the best result for your money.

  4. J

    We currently have 3 months’ worth of emergency fund. I initially wanted to increase this to 6 months’ worth but we have a fair bit of cash available at the moment as we are trying to save for a house deposit. I think the emergency fund that we have now is enough and while it’s not ideal for us to use the house deposit in case of an emergency, it’s comforting to know that it’s available, just in case.

    1. Dividends Down Under Post author

      Hey J, thanks for coming by.

      3 months is great, certainly nothing to sniff at. Something like a third of Australians don’t have any emergency fund savings.. (and I believe that, can see it from the way some people around us approach their money).

      Aiming for 6 months is also the boat we are in, it just feels that little bit more secure and definitely something we want to achieve when we a family of 3. And you’re right that the “house fund” can be a good back up, we hated the idea of using our house deposit fund.. but were so glad we had been saving for it, because that money had to change identity into our IVF fund..
      Regardless of what you mentally allocate the money for, having a good stash is always a good thing.

      Mrs DDU

  5. Remember To Water

    We have sort of merged our emergency fund with out investment diversification. Part of our investment is in low risk (well 0 risk really) cash. This sits in a high interest online savings account (or a couple – ING and UBank currently I believe, but whoever has the best rates). For anything that needs “same day” cash we have credit cards that will get us around $10k to $15k, we then just pay them off a few days later with the savings. The idea is just to get as much interest as we can for the “save” part of our investment mix.

    1. Dividends Down Under Post author

      Hey Tom, thanks for coming by and commenting 🙂 As long as you’ve got cash ready to go I think that’s a good thing to have. Sounds like you have it all figures all out. 🙂

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  7. Jef Miles

    Nice here! Good on you for being conservative with the 6 month figure as a goal 🙂

    I’m generally looking at a similar one to you guys, although I have bucket accounts that I break it down into..

    1. Dividends Down Under Post author

      We would rather be safe than sorry. At the moment we can still get a decent return on our money in the bank – though that is sadly dropping with all the RBA decreases..

  8. Pingback: Should we get a credit card? – Dividends Down Under

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