Establishing and maintaining an emergency fund can help you focus on what's most important when tragedy or other unforeseen life events strike, explains Emma Rapaport.

Family emergencies happen – whether an unexpected death or an unforeseen medical problem, they're an unfortunate fact of life.

When these awful circumstances happen, you want to be able to focus and make the important decisions that are needed, without having to worry about money. And for many of us, we may not even have enough money in savings to respond to an emergency.

Regardless of life stage or situation, emergency funds are a crucial aspect of any financial plan. 

They're not always life-or-death situations either. Even more benign events, such as unexpectedly losing your job or needing urgent car repairs, can be much less detrimental and stressful if you have a little cash tucked away.

For those of us who already have high-interest-rate debt, having an emergency fund can also help guard us against resorting to additional high-cost financing.

Here are the key steps to take when setting up your emergency fund:

 

Step 1 - Define your savings goal

Three- to six-months' of your current salary is a commonly-cited estimate of the ideal emergency fund size. That's a decent starting point, but it sounds hopelessly off-putting to people just getting their financial footing.

In reality, the only living expenses you need to cover with your emergency fund are the very basic ones.

Start by tallying your essential monthly expenses, such as housing costs, utilities, public transport, food expenses, insurance and any regular loan or credit card payments. Leave out any non-essential items such as discretionary clothing, high-cost subscription services.

Multiply your essential living expenses by three months.

This can be your absolute minimum savings target for your emergency fund. From there, you can customise your own amount upward, based on individual circumstances.

Step 2 - Consider how much you can put aside

Take partial stock of your net worth – what you hold in your savings and checking accounts.

Exclude any savings that you have earmarked for short, medium- or long-term goals, such as a new car or purchasing property.

With the amount remaining, consider if you could put any of this money towards your emergency fund. Whatever amount you contribute, this is your current emergency fund.

emergency

Emergency funds are a crucial aspect of any financial plan

Step 3 - Set your emergency-fund savings target

Subtract the figure from Step 2 (your current emergency fund) from the figure in Step 1 (your target emergency fund). This is how much you need to save at a bare minimum – it should be at least double this level.

Setting money aside to hit this savings target should be your main savings priority in the months ahead.

Step 4 - Identify appropriate investments

Putting your hard-earned savings in a standard everyday banking account at almost no interest is unenticing. But your emergency fund is not the place to go searching for extra income via riskier investments.

More importantly, ready access to emergency-fund assets is crucial – when times are tough, you don't need the added headaches of access or liquidity issues, taxes or penalties.

One option is to establish a separate low fee, high-interest savings account. A quick comparison of products shows total interest rates (excluding bonus rates) ranging from 3.10 per cent to 1 per cent annual. Bonus interest rates or promotional rates can take your savings higher, but often have conditions attached, such as 1 per cent extra for the first 6 months.

Make sure you check the fine print and read beyond the advertised rate to ensure the account works for your emergency fund.

Tip: Remember to leave the bank card that comes with your new account at home, or in a secret compartment in your wallet, so you won't be tempted to use it.

Step 5 - Automate your emergency fund savings

Automated saving is one of the best ways you can build up your emergency fund. Even if it's setting and forgetting regular payments of as little as $10-$20 from your regular paycheck, by the end of the year you could accumulate between $520 and $1,040 in your emergency fund. Remember to turn off these automated payments when you've reached your savings goal. 

If you're not a fan of automated payments, some banks now offer round-up services which allow you to save every time you make a purchase. For instance, if you set the round up to the nearest $5 and purchase a coffee for $3.50, $1.50 will automatically go into you savings account.

If you're ever in the unfortunate circumstances where you need to dip into your emergency fund, remember to top it up again.

So ask yourself – if life served up something unexpected, would you be prepared?

  

More in this series

• Investing Basics: Investing Basics: understanding your listed investment company

• Investing Basics: small, mid, large cap - does size matter?

• Investing Basics: Are you paying too much for your super?


Emma Rapaport is a reporter with Morningstar Australia, based in Sydney.

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