05 May Why you need an emergency fund
The importance of having a financial safety net
Have you ever faced an unexpected expense that left you scrambling for cash?
It could be something relatively small and sudden, like an unplanned trip to the dentist, or a larger shock like losing a job.
In both situations, it helps to have a stash of money set aside.
Besides saving you from having to take on expensive short-term debt, an emergency fund can also prevent you from selling investments like stocks and bonds at inopportune times.
Here’s what to know about emergency funds.
How to save for an emergency fund
You can slowly build your emergency fund over time with small amounts.
If you’re starting from scratch, even $20 each week can make a difference: by the end of the year, you’ll have $1,000, which could help deal with an unexpected expense or a larger than expected bill.
Here are some tips from ASIC’s MoneySmart to help you build up your balance:
- Set up a separate savings account: A new high-interest savings account can help you separate your savings from everyday spending.
- Automate your savings: Set up an automatic transfer with your bank, or ask your employer or payroll department to pay a small part of your salary directly into the emergency fund account. This set-and-forget approach means less work for you.
- Consider using an offset account: If you have a home loan, an offset account is a great way to store your emergency fund. It provides immediate access to your money while lowering the interest you pay on your home loan.
- Use a tax refund (if you get one): If you have some extra money from a tax refund, or an unexpected windfall, it can be a good way to boost your emergency savings.
How much should you save in an emergency fund?
The answer will depend on your expenses and your broader financial situation.
While even small amounts can be helpful, ASIC’s MoneySmart says a good target is to have enough to cover three months of expenses.
Depending on your financial situation, you might even want to save more than that — for example, to provide some security from a job loss or if you need to take time off work for caring responsibilities.
When considering how much you’ll need, it’s a good idea to consider any insurance coverage you have. It’s also a good idea to reassess your emergency fund if your spending or circumstances change.
Finally, if you ever draw on your emergency fund, make a plan to top it back up for next time.
Where should you keep your emergency fund?
Vanguard separates financial shocks into two categories:
- Spending shocks: like a broken windshield or a root canal, these are unplanned, unwanted expenses.
- Income shocks: the unplanned loss of income, like losing a job. Income shocks tend to be more expensive and last longer than spending shocks. They also tend to happen less frequently.
Since spending shocks can occur at any time, Vanguard suggests you keep the portion of your emergency savings to cover spending shocks easily accessible, for example in a savings account.
The portion of your emergency savings set aside for income shocks is both larger in amount and will likely be needed less frequently. Because of this, you could consider investing this portion in options with a higher growth potential, like a balanced and diversified portfolio of ETFs in a taxable brokerage account.
The risk is that the value of your investments could drop in value when you need to withdraw them. There could also be tax consequences, especially if you’re selling assets that have appreciated significantly in value over time.
While investments in a taxable brokerage account don’t offer the same safety and accessibility as savings accounts and cash investments, they can still be useful in helping you sustain shocks to your income — and any returns you earn can be used to help fund other goals.
By building and maintaining an adequate emergency fund, you’ll be better prepared to handle life’s unexpected challenges.
Whether you are budget conscious or seeking to maximize your earning potential, we have investment options to help grow your financial nest. Feel free to contact us at info@centrawealth.com.au or give us a call at 08 8231 4709.
Article courtesy of Vanguard.
