The humble emergency fund is an often-overlooked but fundamentally essential component of one’s overall financial portfolio and serves a number of key functions in securing your financial position. If you’ve ever been faced with large, unexpected costs you can either attest to the enormous relief of having an emergency fund in place, or the resultant financial stress as a result of not having access to emergency cash.

What is an emergency fund?

An emergency fund is a specially earmarked sum of money that is easily accessible and that can be used to help cover unforeseeable, high-cost expenses which, in its absence, could have catastrophic effects on your financial position. Ideally, your emergency fund should be clearly earmarked for the purposes of such expenses so that the money does not serve dual or even multiple functions in your portfolio. For instance, a lump sum should not be set aside for emergency expenditure while at the same time being accessible for festive season spending or considered for home renovations. To ensure that you don’t access these funds inappropriately, consider making a list of acceptable expenses the money can be used for.

What are the benefits of an emergency fund?

An emergency fund should do more than prepare you for unpredictable expenses. If saved in the correct vehicle, your emergency fund can earn you interest and act as a safety net to ensure that you don’t need to access high-interest debt if you are suddenly faced with unexpected costs. By building up an emergency fund, you are also increasing your liquid assets which will stand you in good stead when applying for finance and/or credit in the future. Contributing regularly to your emergency fund is a good way of practising and instilling financial discipline, and gives you peace of mind that unforeseeable costs won’t create a massive financial setback. If you’re a contract or freelance worker, an emergency fund can create an excellent buffer against irregular income, providing you with the comfort that you will be able to cover your living expenses even if your income is negatively affected. Importantly, an emergency fund can effectively prevent you from having to borrow against your future self by accessing savings and investments that have been earmarked for other purposes.

What costs can it be used to cover?

Your emergency fund can be used for any costs that are sprung on you unexpectedly. In times of economic uncertainty such as we are currently experiencing, an emergency fund is invaluable in the event of job loss, retrenchment, reduced work hours or pay cuts as it can be used to help cover one’s living expenses. It can also be used for high-cost expenses such as medical costs not covered by your medical aid and/or gap cover, including co-payments, over-the-counter medication, medical devices and appliances, and alternative therapies.

Natural disasters such as flooding and fires can and do happen, and an emergency fund can be used effectively to help with these costs. Remember, even though you may have short-term insurance to protect against such eventualities, the claims processing and payment can take time and access to emergency cash can assist you in the short term.

Other high-cost items include vet bills such as pet x-rays, operations or procedures, unexpected tax bills, expensive vehicle repairs, or emergency travel. While your emergency funds should be reserved for unexpected expenditure, as and when unplanned expenses arise, it’s a good idea to keep a record of them so that you can adjust your budget to allow for these expenses going forward.

Where can it be housed?

The best place to house your emergency funding is in a vehicle that allows you immediate access to your cash, earns interest, and which you ideally cannot access via your debit card. While fixed deposits and notice accounts can earn you interest, there may be some delay in accessing money held in these accounts, and you may be liable for penalties. On the other hand, tax-free savings accounts are more appropriate for long-term savings as any withdrawals made from a TFSA will affect your lifetime contribution limit. Similarly, retirement annuities are specifically suited for long-term savings and the money held in these investments can only be accessed after age 55. If you’re invested in a discretionary unit trust portfolio for a long-term goal, accessing these funds for emergency purposes could result in you having to withdraw when markets are down, thereby effectively losing money.

If you have an access bond facility, this is a great place to save your emergency money. Although you may not physically earn interest, these additional contributions are saving you interest on your bond and provide easy access to cash. Similarly, a designated savings account linked to your primary account – but which can’t be accessed using your debit card – is an excellent place to store your cash. Remember the value of an emergency fund is the unnecessary extra expense of expensive short-term debt rather than the interest you could earn on these saved funds.

Should paying off debt be prioritised over emergency funding?

This is a common debate which effectively has no right or wrong answer. If you have high-interest debt in place, it always makes sense to prioritise paying it off as quickly as possible. On the other hand, there may be good psychological reasons to set up an emergency fund as soon as possible and to get into the habit of contributing towards it – even if it is a nominal amount. Once your debt is paid off, you can redirect your repayments towards expediting your emergency savings.

How much should be kept in an emergency fund?

The optimal amount that should be saved in your emergency fund depends largely on your personal circumstances. If you are a double-income family, the fact that your spouse or partner earns an income is a significant advantage as it provides protection should one of you lose your income. If you have other sources of income, for example, rental or investment income, this also needs to be taken into account.

Your qualifications, skill and the industry in which you operate will also have an impact. If you’re highly skilled in a high growth industry, the likelihood of job loss will be less than if you’re operating in a low growth or stagnant industry. Other factors that should be considered are your health status and that of your spouse and children, the number of children that you have, whether you have pets, the number of vehicles that you own, the size of your property, what level of short-term insurance and medical aid cover you have, and your monthly living expenses. The best advice should be to look at your monthly budget and determine how many months of this level of spending you would feel most comfortable having on hand in an emergency savings account.

How often should an emergency fund be reviewed?

At the very least, you should review your emergency fund on an annual basis to determine whether it still meets your needs. However, with local and global events as volatile as they currently are, you may want to review your emergency funding as and when your personal circumstances change in any way.

Generally speaking, a financial plan includes a number of moving parts, and an emergency fund will help ensure that your other financial goals are not set back or ruined completely. It’s all very well to be optimistic and have a positive outlook on life, but one also has to be realistic about the future. Catastrophes, tragedies, medical emergencies and natural disasters can and do happen, and it is every person’s responsibility to prepare for them financially.

Having an emergency fund in place can be the difference between a hiccup along the road and a complete financial disaster. An emergency fund might not solve the problem entirely, but it can buy you time and options as you consider a way forward. Living on the financial edge is enormously stressful and an emergency fund can give you confidence in the robustness of your overall financial plan.

DISCLAIMER

Originally published by Crue Invest (Pty) LTD on Moneyweb. The content of this post is provided “as is”. MyPlan does not warrant the accuracy, adequacy or completeness thereof, and expressly disclaims liability for any errors or omissions of information.

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This article is for information purposes only and does not constitute financial advice in any way or form. It is important to consult a financial planner to receive financial advice before acting on any information contained herein.