Wednesday, March 12, 2008

Emergency Cash Fund

by Aussie 1 comments

What is an emergency cash fund and what does it have to do with personal finance?

What if you lost your job tomorrow? What about if your car broke down - or your fridge or washing machine. Would you be able to cope with this unplanned expense without undue financial stress? Would you need to borrow money at some exorbitant interest rate to cover the cost until the next payday?

An emergency savings fund is a store of cash or cash buffer put away to cover life's emergencies. No matter how well we plan things, life will always throw unexpected situations at us. This is where the personal emergency fund money comes into play. By having this extra cash put aside, you will be able to meet these challenges without the stress of trying to come up with extra cash at short notice.

There are almost endless possibilities when it comes to unforeseen financial emergencies. Here are some you might like to consider:

  • Breakdown of an important household appliance like a refrigerator,
  • A medical emergency,
  • Loss of employment,
  • Car repairs,
  • House repairs.
Some of these situations may require you to come up with hundreds, if not thousands of dollars at short notice.

If you can't come up with these funds at short notice, what are your options? In the worst case scenario, you may have to borrow money from a short-term money lender (think cash advance, payday loan or something similar) at very high interest rates. If you have a credit card, you may be able to use that, but once again you may face a steep interest bill. If you're lucky, you may be able to borrow the money from friends and family. However, not everybody is this fortunate, and even those that do have this option may prefer not to go down this path. Borrowing money from friends or family can place undue stress on relationships.

So how do you get started with an emergency cash fund?

Hopefully, you're in a situation where you're able to save some money on a regular basis. If you currently aren't saving any money, I would suggest you review your personal financial situation. You may need to cut back on your spending - have a look at your expenses and think realistically about what you can do without. Start with your discretionary expenses.

Assuming you are putting aside a little money each week or month, this is the money you should be putting into your family emergency fund. Set yourself a target (say $1,000) and concentrate on putting this much aside over a number of months. This should be your top priority and all of your saving efforts should go towards this goal until you feel you have enough put away.

It's important for this money to kept separate from the rest of your finances. You will need to resist the temptation to dip into it for special purchases - that new large screen TV or the holiday. Even worse, you don't want it to be frittered away on everyday living expenses. You need to make sure that the funds will be available should the need arise. Remember, it's for emergencies only.

How Much Is Enough?

I mentioned a figure of $1,000 earlier. This figure is somewhat arbitrary. I think it's a good starting point and is far better than not having an emergency fund at all. But I would suggest that most people would need more than that.

How much more? Well the consensus seems to be about 2 - 3 months pay (or even more). It will depend very much on your personal circumstances though. Factors to consider include the following:
  • How many dependents do you have?
  • How much if any health or medical insurance do you have?
  • How secure is your job?
  • What are your monthly expenses?
A young single person with no dependents could obviously get by with a much smaller emergency fund than a married couple with 3 dependent children and a mortgage. Consider each of the likely scenarios and work out how much you would need to meet the unexpected costs.

For example, you may allow $1,000 for a replacement refrigerator. You may also consider $2,500 to be enough to cover any major car repairs. And you may think that 2 months would be long enough to seek alternative employment, and if your living expenses are $2,000 per month then you would need to put aside $4,000 to cover this eventuality.

In the above example, you might like to set the amount for you emergency fund at $4,000 as this is the greatest figure out of the scenarios you have considered. It's unlikely (but not impossible) you would encounter all of the above situations at once, so I would just make sure I have the most expensive one covered.

Where Should You Keep Your Emergency Cash Fund?

Because in the event where you need to make use of your emergency fund you will need access to the money at short notice, I would suggest you keep it in cash or a cash equivalent. This means an at call savings account (maybe on online savings account to maximize the interest you can earn). Or you may want to consider a short dated term deposit or CD (certificate of deposit). The main thing to remember is that should you need to call on your emergency fund, you will most likely need the cash in a matter of days.

Many personal finance experts may consider an emergency fund to be an inefficient use of your resources. In some cases this can be true, but it will depend on your personal circumstances. In my next post, I will discuss more advanced concepts in managing your emergency cash fund.

Comments 1 comments
Kelli said...

Saving for emergencies is very important. I generally prefer saving a certain percentage of my monthly income for such situation. Although at a time of crisis all the funds become emergency funds, but still it is better to keep oneself prepared for an emergency.Kelli