Why you need an emergency fund

Joseph Darby

Most financial experts say that you should have a sum of money set aside that totals at least three to six months of living expenses. This should be readily accessible and is commonly called an emergency fund.

Despite this, according to NZ comparison site “Finder”, as of February 2020 more than a third of Kiwis only have enough money to get from one payday to the next, and one in five of us can only cover our expenses for a week or less if our income suddenly stopped. These numbers are consistent with the findings of a 2017 study completed by BNZ.

Anyone living ‘paycheck to paycheck’ usually has limited or no savings (as they have no surplus income to save) and are putting themselves at great financial risk if the unexpected occurs, such as unemployment.

Read-on for the top six reasons why having an emergency stash is a great idea, and if you already have one, why it might be a great time to ramp up the contributions.

1. Gain confidence through preparation

“Expect problems and eat them for breakfast” – Alfred A. Montapert

It can be terribly stressful to know that you’re vulnerable to any disruption to your income, or any unforeseen expenses. In practical terms, this could mean struggling to put food on the table if the car requires mechanical repairs, or just knowing that something unexpected would put you further into debt.

Instead, it’s best to be realistic and acknowledge that through the course of your life you will experience the ‘unexpected’, which could be in the form of events such as:

  • Expense issues. For example, a car which has broken down, unplanned travel to see a sick relative, a broken washing machine or other appliance, health or dental costs, etc. Or,
  • Income issues. For example, a job loss, your own health issues limiting earning potential, family members health issues requiring you to look after them instead of work, or any other event which leads to a drop in income, etc.

Anyone who’s realistic will acknowledge that ‘unexpected’ things happen and are just a normal (even if unplanned) part of our lives.

When you accept this, then take practical steps to prevent these issues being a major disruption, it creates a sense of confidence. This confidence will enable you to sleep a little easier at night and focus on what really matters.

2. Keep you on track towards your goals

Whether or not you’ve made a deliberate decision to, you’re working toward a financial goal. For many, this will be funding your retirement nest-egg and for others, it will be buying a first home, or paying off the mortgage on your existing home.

If you don’t have an emergency fund then every time you run into a financial issue, you’ll have to spend some or all the funds that you’re investing towards your financial goals to finance these unexpected costs. This reduces the results of your efforts to strive towards the things that really matter and means you’re more likely to lose heart in the things that really motivate you.

With an emergency fund in place, you’ll be able to navigate life’s inevitable storms without accessing funds which are invested and may be difficult to get to, and/or subject to variations in value.

Don’t let a ‘bump in the road’ divert you from reaching your financial goals.

3. Avoid emergency borrowing

Lenders charge a high amount of interest for short-term borrowing. Without an emergency fund, borrowing from these lenders for something such as your car breaking down means that over the course of the loan you will be paying a lot more than you initially borrowed.

This includes debt on credit cards, which can quickly accrue interest at very high rates.

4. Create good habits

Putting aside some of your income for an emergency fund is a commendable act. Taking steps which seem small at first can add up to a great overall result – and the important first step of setting aside funds is one of them.

While our advisers often recommend people to keep regular savings and emergency funds separate from each other, the same overall principles apply to boost both funds or any investments – the more you set aside on a regular basis, the more you’ll have.

With any investment or emergency fund, it also helps to avoid accessing it unless something that meets pre-agreed criteria has occurred. It’s best to agree in advance about such criteria with your spouse or other family members. This sort of conversation can also be the start of forming other great financial habits, such as agreeing on how much and where to invest to achieve the things you really want in life.

5. As one part of a risk management plan

Emergency funds are part of an overall risk management plan – protecting you against unpleasant life events.

Naturally, the total sum required differs between each person’s individual circumstances, as well as a reasonable estimate of what emergency costs they may be expected to meet – this means there is no “one size fits all” approach. One of the reasons most financial guru’s suggest having enough of an emergency stash to cover three to six months’ worth of regular expenses is because that’s when most people arrange their income protection insurance to kick in, for example, if they become too ill to work.

6. Your emergency fund will slowly but steadily grow

Most people's emergency funds are best kept in a bank savings account. Most banks offer competitive interest rates for online accounts when you make a small deposit and no withdrawals each month. This means your contingency fund will still slowly but steadily grow.

If you’ve already got an emergency fund, now might be the perfect time to set up an automatic transfer into your already-existing fund or to increase that automatic contribution. It can help protect you against some of the risks that come with a recession.

Ideally, your emergency fund should not be at the main bank you use. You’ll still have easy access when you need it, but the access isn’t convenient because you probably won’t be carrying around a debit card that can easily access the emergency fund. Instead, the card for accessing that fund should be stored in a secure place at home.

Remember, the only purpose of an emergency fund is to be there for you in emergencies. Outside of that, just pretend that it doesn’t exist.

The bottom line

When you have no emergency savings, you will most probably encounter unforeseen issues that have a far larger impact on you than they need to. Having an easily accessible stash means you can pay for such eventualities without interfering with your major goals. To recap, here are the top six reasons why you need an emergency fund:

  1. Gain confidence through preparation
  2. Keep you on track towards your goals
  3. Avoid emergency borrowing
  4. Create good habits
  5. As one part of a risk management plan
  6. Your emergency fund will slowly but steadily grow