What is... | September 20, 2012

What is an emergency fund?

An emergency fund is essential for healthy personal finances. But even many who understand the importance haven’t built one.

An emergency fund is readily-accessible cash for use – as the name suggests –  when an unexpected disaster strikes. Some call it “rainy day savings” which can be called on when times get tough. Experts suggest three to six months of take home pay is a decent size for an emergency fund; there is no agreed single figure.

It will depend on how much an individual spends, whether they have dependents, a mortgage, insurance, and other factors such as job security. 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 their funds should make their emergency savings harder to access, forcing them to think twice before spending it.

Is a new car an emergency?
Holidays, dinner out and other non-essential spending are not, generally speaking, an emergency. On the other hand, job losses, health problems, and breakdowns might be.

Whether a car is essential will depend on individual circumstances – but it is likely that a new car should be saved for separately. Funds that will cover car maintenance should be budgeted for as well ahead of time, and therefore not be an emergency.

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 comparing your income against your expenses to see how much money can be saved each pay day. 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.

SavingMental accountingEmergency savings

eZonomics team
.(JavaScript must be enabled to view this email address)