Everyone has experienced an unexpected financial emergency.
And amid the current cost-of-living crisis, when the cost of groceries, utilities and mortgage repayment bills are high enough already, an added out-of-the-blue expense could be enough to send your finances into a tailspin.
From a broken window to an unexpected medical bill or even a loss of income, it always feels like these unexpected expenses come at the worst time.
Enter… The emergency fund.
Many financial advisers say that you should regularly contribute to an emergency fund to help protect yourself against unplanned expenses, recover quicker and get back on track when they do.
Here’s a breakdown of everything you need to know about emergency funds, including what the average Australian has and what should be in your account too.
What is an emergency fund?
An emergency fund is simply a cash reserve that has been specifically saved and set aside for unplanned expenses or financial emergencies.
Emergency savings can generally be used for large or small unplanned bills or payments that are not part of your routine monthly expenses and spending.
What are the benefits of an emergency fund?
Having an emergency fund provides several important benefits that can significantly enhance financial security, resilience and stability.
1. It gives financial security
An emergency fund acts as a financial safety net, providing you with the peace of mind that comes from knowing you can cover unexpected expenses, such as property damage, medical bills, car repairs, or job loss.
This reduces the stress and anxiety associated with financial emergencies, allowing you to handle unforeseen situations without disrupting your long-term financial plans.
2. It helps avoid debt
One of the primary benefits of an emergency fund is that it helps you avoid taking on debt during unexpected situations.
Without an emergency fund, you might have to rely on credit cards, personal loans, or other high-interest borrowing methods to cover sudden expenses.
This can lead to a cycle of debt that is difficult to break, but by having savings set aside, you can pay for emergencies without accumulating debt.
3. It gives you flexibility and freedom
With an emergency fund, you have more flexibility in your financial decisions.
For example, if you lose your job, an emergency fund can give you the financial cushion needed to search for a new job without rushing into the first opportunity out of necessity.
It also allows you to take calculated risks, such as starting a business or making significant life changes, knowing you have a financial buffer to fall back on.
4. It protects your long-term savings
An emergency fund helps protect your long-term savings, such as retirement accounts or investments, from being tapped into during financial crises.
By having a separate fund for emergencies, you can avoid withdrawing money from retirement accounts or selling investments at a loss, which could negatively impact your long-term financial goals.
5. It gives peace of mind
Knowing that you have an emergency fund in place provides peace of mind.
It allows you to live with less financial stress and worry, as you are better prepared to handle life's uncertainties.
This emotional benefit is just as important
What does the average Aussie have in their emergency fund?
In a survey published by the Melbourne Institute, the research team asked over 1,100 Australians how they would cover an unexpected expense of $3,000 if it occurred in the next month.
Almost 20% of respondents said they would not be able to cover an emergency expense and a further 12.5% (on average) would turn to a loan or credit card to help.
Source: ABC/ Taking the Pulse of the Nation by Melbourne Institute and Roy Morgan
And a recent InfoChoice ‘State of Aussies’ Savings' survey shows that more than a quarter (27.3%) of the survey’s respondents had less than a month’s income in savings.
That jumped to nearly a third (30.9%) of Gen Xers - most likely because of mortgage commitments.
Renters were more than twice as likely to have less than a month’s income in savings compared to homeowners, at 43.2% versus 19.6%.
The rule of thumb for a healthy emergency fund balance is between three to six months' worth of expenses.
However, more than half of all respondents (52.2%) had three months' income or less in their savings stash.
Here’s how much you should have saved in an emergency fund
The general consensus amongst financial advisers is that you should keep adding to your emergency fund until you have three to six months of your living expenses.
So, if you spend $5,000 per month, your first emergency fund savings milestone should be $2,500 to cover spending shocks.
For your longer-term goal of an emergency fund that will cover income shocks, aim to save $15,000 to $30,000 total.
This is to cover your basic needs such as rent or mortgage, utilities, groceries and insurance.
But, of course, that figure can be difficult to achieve, especially in today’s environment when so many people are living paycheck-to-paycheck.
Here’s where you should have your emergency fund savings
When deciding where to keep your emergency fund, the goal is to find a balance between accessibility, safety, and some level of interest earnings.
Generally, there are two key options: A high-interest savings account, or for homeowners, an offset account.
A high-interest savings account is one of the most popular places to keep an emergency fund because it offers easy access to your money, typically allows for unlimited withdrawals, and provides interest on your savings.
But, savers need to keep an eye out for monthly fees and competitive interest rates to make sure the emergency fund grows over time.
An offset account is a good option for holding an emergency fund if you have a mortgage.
An offset account is a transaction account linked to your mortgage, and the balance in this account is offset against your home loan, reducing the interest you pay.
This means that not only is an offset account liquid, like a regular savings account, meaning you can easily access funds whenever needed, but the money in the offset account directly reduces the balance on which interest is calculated, resulting in significant savings over the life of the mortgage.
It’s also a tax-efficient option because the savings on your mortgage interest are not considered income, you avoid paying tax on the interest savings, unlike interest earned in a regular savings account, which is taxable.
It sounds like a lot of money to save, how can I build an emergency fund?
Creating an emergency fund requires dedication and a plan. Here’s a step-by-step guide to get you there.
Step one: Set a goal
Determine how much you need in your emergency fund (remembering the common recommendation of 3-6 months’ worth of living expenses), then calculate your monthly expenses, including rent or mortgage, utilities, groceries, insurance, and any other necessary costs.
Multiply this by the number of months you want to cover to set your goal.
Step two: Create a budget
A budget helps you track your income and expenses, making it easier to identify how much you can save each month.
List your income and all your monthly expenses, then see where you can cut back to free up money for your emergency fund.
Even small changes, like reducing dining out or cancelling unused subscriptions, can make a big difference.
3. Automate your savings
Set up an automatic transfer from your checking account to your savings account each payday.
Automating your savings ensures you consistently contribute to your emergency fund without having to think about it, making it easier to reach your goal over time.
4. Start small and build momentum
If saving 3-6 months of expenses seems overwhelming, start with a smaller goal, like $500 or $1,000.
Then, once you reach that milestone, gradually increase your savings goal.
This approach helps build momentum and keeps you motivated as you see your savings grow.
5. Savings windfalls
Whenever you receive unexpected money, such as a tax refund, bonus, or gift, consider putting a portion - or all - of it into your emergency fund.
Windfalls can give your savings a significant boost without affecting your regular budget.
6. Reduce your debt
If you have high-interest debt, such as credit card debt, it might make sense to allocate some of your funds to paying it down while still contributing to your emergency savings.
Reducing debt can free up more money in your budget for savings in the long run.
7. Monitor and adjust
Regularly review your savings progress and adjust your budget or savings plan as needed.
Life changes, like a new job or a change in expenses, might require you to revisit and update your emergency fund goals.
A final note…
Setting up an emergency fund is a wise choice to protect yourself from unforeseen financial issues or out-of-the-blue bills.
It provides a safety net that helps you navigate unexpected expenses without derailing your long-term financial goals.
Whether it's a sudden property expense, medical bill, car repair, or loss of income, an emergency fund ensures you don’t need to rely on high-interest debt and you don’t need to dip into savings meant for other things.
The trick is to start small and keep adding to it, and make sure you only dip into it when necessary.
Don’t be tempted to remove funds from it for everyday spending, it’ll defeat the point and before you know it you’ll be back to step one.
