An Emergency Fund – Why You Need One And How To Start One?

By FutureNestEgg | July 24, 2008

Financial Pundits recommend that everyone must have an Emergency Fund. Here is some information about the importance of Emergency Funds and hopefully by the end of this post, I would have convinced you to start one (if you don’t already have one).

What Is An Emergency Fund?

Funds that you can access in case of unexpected events in your life is called an Emergency Fund. This money is not for buying the latest gadget or a good pair of shoes. It is purely for emergencies in your life. Emergency is something which threatens your usual way of day to day living.

Here are some examples:

1. Losing your job
2. You or your family member meets with an accident
3. Illness
4. Roof collapses in your home

Some people wrongly believe that if you have Income Protection Insurance, you don’t need an emergency fund. There are lot of emergencies that the income protection insurance will not cover.

Why Should You Have An Emergency Fund?

Here are three common reasons for not having an Emergency Fund:

If and when such an unexpected event occurs, I will definitely find some way of accessing cash and hence there is no point saving for it NOW.
There are lots of other needs that I need this money NOW and hence cannot afford to save it for later.
I need to concentrate on paying off my mortgage. That is my only priority for NOW.

If you don’t have an emergency fund, when an emergency situation arises, the quickest way one would get access to money is through credit cards or through loan sharks. Both of these charge high interest rates. These debts will take a long time to clear off. By the time you clear them off, you would probably end up paying much much more than you originally borrowed (due to the high interest rate).

Worst case scenario would be if you had to sell off the assets you own to repay the debt. You need to realise that whilst it is important to invest wisely and grow your wealth, it is also equally if not more important to protect what you already have.

How Much Money Do You Need In An Emergency Fund?

The consensus among financial experts is to have at least 3 to 6 months of living expenses in the fund. The living expenses would include your rent/mortgage, monthly repayments for your current debts (like car loan), school fees, groceries and utility bills.

It probably does not make much financial sense to have money stacked away if you have other debts at the moment. Dave Ramsey, author of the popular personal finance book -The Total Money Makeover : A Proven Plan for Financial Fitness – recommends that you save $1000 initially and then concentrate on eliminating your debts. Once the debts are eliminated you can increase the emergency funds to bring it up to a level so that it can cover at least 3 to 6 months of living expenses (the debts does not include your home mortgage).

Most of us will probably not be able to contribute a lump sum to the fund. I suggest a ‘savings plan’ – contribute a small amount every month. During the accumulation phase, treat regular contribution to emergency funds as a bill. You will not leave a bill unpaid so hopefully by treating these contributions as a bill, you will have the discipline to stick to them.

Which Fund Is Most Suitable?

Before I recommend some funds, here are some basic features an emergency fund should have:

Should Be Easily Accessible – When you do need these funds it will be an emergency situation. So you should be able to withdraw them without too much fuss.
Should Not Be Too Accessible – If you have an ATM card, you will be tempted to withdraw from the fund.
A reasonably good interest rate. When you open the account, the hope is that you might not need the funds for a long long time. So low interest rates will not do. You want it to multiply at a decent rate.
No fees

One of the following account types can work well for an emergency fund:

1. Online Savings Accounts – They offer high interest rates. They don’t come with an ATM card (which is good news) and you can’t make withdrawals from a branch. The only way you get money out is to use internet or telephone banking and transfer funds from this account into your every day savings account. If your every day savings account is with a different bank to your online savings account, you need to check if the transfer of funds can still happen.

2. Cash Management Accounts / Cash Management Trusts: High interest rates. They don’t make withdrawing too easy – having said that some come with ATM cards. The only drawback would be that almost all need around $5000 initial deposit.

Some of the high interest accounts (with low initial deposits) are:

1. BankWest TeleNet Saver – Online Savings Account

2. Direct Dragon Account From St.George

3. HSBC Serious Saver Account

4. RaboPlus High Interest Savings Account

There are a few more high interest accounts in the market. Do your research and pick the one that suits your needs and circumstances.

Mortgage As An Emergency Fund

If you have a mortgage with a redraw facility and you regularly make additional payments into your mortgage, then before you decide on using that as an emergency fund, check the following:

1. Minimum amount you can withdraw
2. Maximum amount you can withdraw
3. Fees for redraw
4. Maximum number of redraws allowed in a year
5. How easy is it to redraw – if it is going to take three days to get access to your funds then it defeats the entire purpose of an ‘emergency fund’.