Having an emergency fund is essential for financial security and stability. It serves as a safety net to cover unforeseen expenses and unexpected loss of income, preventing the need to accrue consumer debt. Additionally, an emergency fund provides more flexibility in career choices, living arrangements, and lifestyle, as it reduces the dependency on your income for immediate financial needs.
An emergency fund is just as important for retirees as it is accumulators. For retirees and those nearing retirement, an emergency fund can safeguard your retirement savings, preventing the need to take unplanned ad-hoc withdrawals from your portfolio which, in turn, reduces sequencing risk.
The amount of emergency fund you need, depends on your individual circumstances. Typically, it is suggested that you hold 3 to 6 months of living expenses, but your Financial Adviser will be able to help you tailor this to your specific needs.
Where to house your emergency fund?
It is typically not recommended you invest your emergency fund as this can delay access to the funds and may expose you to market risk. Instead, emergency funds should be held in cash. If you are debt free, then a high interest savings account should be considered. If you have a mortgage, you could consider an offset account or redraw to house your emergency fund as the interest saved against the mortgage will likely be higher than interest generated on a savings account.
When selecting an account to house your emergency fund, you should consider if the deposit is protected under the Financial Claims Scheme (FCS). The FCS is a government-backed safety net for deposits of up to $250,000 per account holder per authorised deposit-taking institution (ADI). This protects your deposit in the unlikely event of the failure of a bank of the deposit taker.
Benefits of an emergency fund?
The BENEFITS of an emergency fund include the following:
- Financial security and peace of mind: An emergency fund provides financial security and peace of mind by offering readily available funds to address unexpected expenses or loss of income. This buffer empowers you to handle urgent needs without compromising long-term financial goals or facing difficult trade-offs, reducing worry and stress.
- Lifestyle Flexibility: Having cash readily available means you can make better lifestyle decisions without worrying about funding living expenses in the short-term. An accessible emergency fund allows you to take career risks like starting a business or quitting an unsatisfying job to find greener pastures.
- Earning interest: Housing your emergency fund in a high-interest savings account allows your money to grow through compounding interest while remaining easily accessible when needed.
- Saving Interest: Utilising an offset account or redraw facility for your emergency fund can result less interest paid on your mortgage. This can help reduce the time taken to pay out the loan as more of your repayment will go towards capital rather than interest.
Risks of an emergency fund
The potential RISKS of an emergency fund include the following:
- Limited Return on Investment: Cash investments may not earn enough interest to keep pace with inflation, potentially eroding their value over time. Even accounts offering the highest annual percentage yields often provide minimal returns, compared with other asset classes.
- Impact on Government Entitlements: Bank accounts are factored into Centrelink means testing, potentially reducing entitlements.
- Balancing Needs and Wants: Allocating surplus funds to build an emergency fund may require temporary sacrifices in non-essential expenses, such as leisure activities, luxury purchases, or premium memberships. While redirecting surplus away from indulgences may be challenging initially, the focus should be on building financial resilience and reducing vulnerability in the face of unpredictable circumstances.
- Managing Temptation: As the money is readily accessible, there is always a temptation to dip into your emergency fund for discretionary purposes. It’s important to exercise discipline and refrain from using emergency savings for non-essential spending, ensuring the fund remains intact for its intended purpose.
How to build an emergency fund
Building an emergency fund doesn’t have to be complicated. With some simple planning, you can start saving for the unexpected by choosing an appropriate account to house your savings and setting yourself a regular savings target.
