By now, you’ve probably heard about emergency funds and why you should have one. Is it really necessary? If it is, how much should you have and where should you put it?
What about your house deposit and other short-term savings. We’ll answer all these questions in this blog post.
What is an Emergency Fund and Why is It Important?
Simply put, an emergency fund is money that you have for an unexpected life event.
It is the cash you have available to pay for unforeseen expenses, such as but not limited to:
- Major car trouble
- Medical expenses
- Leaky roof
- And perhaps the costliest of all: losing your job or unemployment
When you have an emergency fund, you create a financial buffer, so you remain afloat despite the mentioned emergencies above. It means you do not need to take out a loan with high interest to survive. It also does not involve relying on your credit cards. Basically, it’s the key to avoiding borrowing more, especially if you already have debt.
Emergency funds can be anything from your offset account to the redraw facility on your home loan. Often, when you have a home loan, you have an offset account where you can keep your emergency savings. This way, the funds also work to lower the interest on your home loan while having ready to access cash anytime. Please note that you will not earn when you have money in this account. Therefore, it can take a while for it to build up your savings.
A redraw facility works almost the same way. You can use it to make home loan overpayments. But more importantly, when faced with the unknown, you can redraw your extra payments.
Another type is a margin loan, which can be quite risky but has a big payoff when the markets go up. But it is not for everyone because it can be difficult to understand. With a margin loan, you can borrow money so that you can invest in shares or managed funds. However, the lenders will need you to maintain a loan to value ratio (LVR) to an agreed level, which is typically 70%.
You can also use credit cards to pay for emergency expenses. However, you probably already know about their high-interest rates, especially if you cannot pay them off right away.
A great way to have available funds is through investment. For instance, you can sell your investment property to pay for a serious health event. Stocks and bonds are also an option but remember that your money will be less liquid. Also, you subject it to considerable and often unavoidable risk.
Of course, the best way is to have cash that you can readily tap into. It’s the most convenient option, particularly in keeping yourself liquid.
How Much is Enough?
Regardless of the type of emergency fund, one thing that many people want to know is the amount. How much should your emergency fund be? The answer is: it depends. You first have to assess your life situation, the potential risks and liabilities that you could face, and your expenses. These factors will tell you how much of an emergency fund is necessary.
For most people, they require at least three months’ worth of savings, especially in the event of unemployment. The more savings you have, the better, of course. However, you still need to go back to your own circumstance. Is it necessary that you have up to half a year of expense? Your financial situation will determine how much you need to set aside for an emergency. But to be completely safe, a good rule of thumb is to be prepared three to six months for your living expenses.
If ever you do lose your job, you could use the money you have available to pay for necessities until you find a new work opportunity. Or, you could have the emergency funds for supplementing the unemployment benefits you will receive from the government, for example.
Here are some sample scenarios to help you decide:
- A two-income household: Three months’ worth of emergency fund
- A steady job for several years: Three-month emergency fund
- One-income family: Six months
- Self-employed: Six months
- Earning straight commission: Six months (especially in case of a job loss)
- A household member with a chronic medical condition: Six months
One thing that you need to know about an emergency fund is that you do not have to have a significant amount saved up. However, it is essential that you save. Start small, but start now, and you can build the fund over time.
Where to Put Your Emergency Fund
So you are ready to begin. The question now is, where should you put it? Here are some of the best places:
- High-Yield Bank Account: It’s probably the easiest place for you to keep the fund. Most Australians have a savings account, which is easily accessible, and you can even earn interest when you save money in it. The right account comes with competitive interest rates with no monthly fees or even a balance requirement. You can also open a new account to avail the welcome bonus, which is a constant offer in many banks.
- Offset Account: If you are a homeowner, you have an offset account, which is a transaction account linked to your home loan. Any money you have in the offset account will cancel any home loan that is payable each month. In other words, you lower your interest payments while also gaining access to money quickly.
- Automatic Transfers: With your bank account, you have the option to deposit a lump sum each month. The amount represents your living expenses. You can also build-up to this specific amount through automatic transfers. How much should you automatically transfer? It’s all up to you. For smart money-savers, they typically save about 10% of their paycheck. Choose what’s safe for you while also considering your target.
An optional step to take is to have a cash buffer. Having a good little buffer for quick emergencies can truly help. You can have a small amount in a jar or envelope, for instance, five dollars a week. It’s not much, but it could end up being a lifesaver.
Emergency Funds and Buying a House
A common dilemma that potential homeowners have is whether they should allocate funds for emergencies or their home deposit. How do you structure your savings if you plan to purchase your first home? An excellent way to solve this uncertainty is to think of your future. You may think that in three to five years from now, you want to buy your first house. How certain are you that you will reach that goal in that timeframe?
One thing that you can do here is to be as flexible as possible. In many cases, renting is much more expensive than buying a house. It may be your motivation to jump into homeownership as quickly as you can. So now, you are probably thinking, you will just save for the down payment, and all the costs involve. Then, you will worry about the emergency fund later after you buy the house.
It sounds like a great plan, but here’s the problem. Many mortgage lenders will not give you a loan when you do not have money left after you have paid for the down payment, closing costs, and others. It is why it makes sense to have at least a portion of your targeted emergency fund spare before applying for a mortgage.
It’s all about reserves with a mortgage. Most of the time, you need to provide the following requirements:
- Collateral based on the value of the property
- Assets, including your down payment and cash reserves
Usually, people talk about credit and down payment, the most but often neglect the importance of cash reserves. They pertain to money that you can access easily, such as the funds in your savings accounts, bonds, mutual funds, checking accounts, and retirement assets. What every lender wants to know is if you do lose your job or there are any difficulties, will you still be able to pay your mortgage? The answer should always be “yes.”
Even when you are ready to pay for the down payment, you should still put down a little portion of your money for emergencies. During this time, however, your focus is on paying for the house. You may be worried too much about the cash that goes to your rent. But if you have financial goals and a plan to achieve them, you are not wasting money. It’s just a step towards winning long-term, especially once you have a strong financial foundation.
What to Do Before You Start Saving for Emergencies
Starting to build up your emergency fund is great, but there are things that you need to do first before you pile your spare money in a convenient place. Make sure you are prepared, especially if you currently have credit card debt or unauthorised overdraft. If you have, arrears on your mortgage repayments, or any other debt, it makes sense that you pay them off first before you focus on emergency funds.