What is... | September 20, 2012

What is an emergency fund?

An emergency fund is one of the essentials of healthy personal finances. But even many people who understand how important emergency funds are haven’t built one.

My emergency fund is quick to access
An emergency fund is readily accessible cash for use – as the name suggests – when emergency strikes. Some call it “rainy day savings”, as the money is called on when times get tough.
Experts suggest three to six months of take home pay is a decent size for an emergency fund but there is no agreed single figure. It will depend on how much an individual spends, if they have dependents, a mortgage, insurances and other factors. Job security is also a factor. Shift workers and other employees with variable hours are particularly vulnerable to sudden falls in income.
The buffer needs to be easy to get to (not tied up in bonds, shares or other less accessible assets). Those prone to dipping into funds in non-emergencies should make it a little bit difficult to get to, thinking twice before getting access to the emergency fund on their cash card.

Is a new car an emergency?
Vacations, dinner out or other non-essential spending do not fall within the definition of an emergency.
On the other hand, being made redundant, discovering an unexpected health condition or your oven breaking are among the major, unpredictable events that the emergency fund can help pay for.
Whether a car is essential will depend on individual circumstances – so for some, fixing a breakdown could be a justified use of an emergency fund but it is likely that splashing out on a new car “just because” is not an emergency and should be saved for separately. In an ideal world, ensuring funds are available to cover a breakdown would have been in the budget associated with owning a car.

How to build an emergency fund
Our video How much should I be saving? explains simple steps to build a rainy day fund.
It involves building a basic budget by assessing income and expenses to see how much money can be saved each pay cycle. Build a savings habit by opening a dedicated emergency fund account, giving the account a suitable name and setting up automatic deposits at the start of the pay cycle to build up to the amount you need in your emergency fund.
Putting money into savings at the start of the pay cycle is known as “paying yourself first” and prioritise saving. It can be a powerful strategy.
If a person has debt, they can often be unsure if they should pay the debt off before starting an emergency fund. An earlier eZonomics poll says the key is to strike a happy balance, with individuals choosing how much debt they are comfortable paying while saving for an emergency at the same time.

How fragile are our finances?
A test of financial fragility is whether an individual could pay an unexpected $2,000 bill in a month. Research on the Brookings Institution website tells about how a quarter of US respondents in a major poll in 2009 were certain they could not come up with the sum, rising to about half when those who probably could not were added. In comparison, 27% of those surveyed in the Netherlands and Canada would have trouble, 37% in France, 46% in Portugal, 50% the US, 51% in Germany and 52% in the UK.
The eZonomics story How fragile are our finances?  explains further.
The ING International Survey on Savings 2011 gave a similar result, surveying savings behaviour in 19 countries.

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eZonomics team
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