As all life rafts and safety devices go, we hope never to use them. We maintain them, repair them, and keep them around – ironically with the aim of never using them.
In the financial context, the Life Raft I am referring to is your Emergency Fund. You may think to yourself, “Hey, I got insurance for all sorts of contingencies, isn’t that my bloody Life Raft already? I spend 15% of my salary just for protection, what more must I do?”
And to that I say: good job, well done. Now, about your Emergency Fund…
What is an Emergency Fund used for?
For emergencies that insurance does not cover.
Most of the time, that is when you lose your ability to (temporarily) earn an income, say via retrenchment.
You will not be able to claim on any of your insurance policies, for it is not death, nor serious illness, nor an accident. To actually get into an accident just for the claims money is rather extreme, please don’t do it.
This is when the emergency fund (the financial life raft) kicks into gear. It ensures that you are able to sustain your monthly expenses such as your mortgage, your car loans, credit card bills, and even life insurance premiums.
What is an Emergency Fund NOT used for?
Holidays, obviously. Taxes. Stuff that happens periodically, which you can reliably foresee.
This would include car repairs and maintenance, breakdown of major electronic and household appliances like washing machines, air-conditioners etc.
An emergency fund should not be dipped into for these sorts of expenses. A good suggestion would be to set aside a small amount of money every month for when these things happen. (A rainy day fund perhaps?)
If incorrectly used, your emergency fund could be depleted without you knowing it and be made unavailable when an emergency does occur. You could incur some additional credit card bills, but is 24% p.a of interest really the type of loan you want to go for?
Size matters. (That’s what she said too)
Emergency funds should be of the right size, and here’s why.
Your money sits there unutilized, collecting dust. You may lose out on investment opportunities which ultimately slows down your wealth accumulation process.
A fund that is too big is also hard to save for!
Even worse than a fund which is oversized. When you are underfunded in an emergency, you tend to be left with expensive options of credit (credit card debt), or selling your investments at an inopportune time (resulting in losses), or even surrendering life insurance policies prematurely.
Not at all a good position to be in.
How to determine the right size for your Emergency Fund
Make no mistake, even financial experts cannot agree how much is enough.
A common piece of advice is 3 – 6 months of your income.
What about 3 – 6 months of your expenses instead? That makes great sense as well.
To help you out, here is a list of questions to consider.
- Are you the sole breadwinner of the household? If yes, you need a larger fund
- Is your job/income prone to recession or market downturns? If yes, you need a larger fund
- Are most of your expenses necessities like food, utility payments, mortgage etc (vs discretionary or luxury purchases) If yes, you need a larger fund
- Do you have one or more financial dependents? If yes, you need a larger fund
- Are you able to earn an alternate income quickly, like tuition or a part time job? If no, you need a larger fund
If you answered yes to 1 – 3 of the questions above, your emergency fund should at least be 5 months (of your monthly income).
If you answered yes to 4 or 5 of the questions above, then it will be good to have a fund of at least 8 months.
If you answered no to all the questions, then you probably will get by comfortably with a fund of 3 months.
Any emergency fund less than 3 months is likely to be too small. On the other end of the spectrum, any fund above 1 year of income is probably generous to a fault.
Planning for contingencies is never easy and if you are unsure if you have enough, rest assured that you are not alone.
If you have a financial adviser serving your needs, you should consult them.
Alternatively, reach out to us for help ( email@example.com ), or visit our forum. A second or third opinion can never hurt, because it may give you new perspectives or angles that may have been overlooked.
But don’t delay!
It pays to be prepared well before the iceberg hits your ship.
www.ClearlySurely.com aims to eradicate the knowledge gap between consumers and Life Insurance. Our Vision is that one day, every Man, Woman, and Child will be properly insured.