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Investing basics: how to set up an emergency fund in 5 steps

Emma Rapaport  |  23 Mar 2020Text size  Decrease  Increase  |  
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Layoffs. Lost shifts. Events cancelled. Mass shutdowns and social distancing in response to the spread of Covid-19 are affecting workers across the world.

When such unexpected things happen, you want to be able to focus and make the important decisions without having to worry about money.

If you don't already have an emergency fund, now would be a good time to build one. Regardless of your life stage or situation, emergency funds are a crucial aspect of any financial plan.

They're not always life-or-death situations either. Unexpectedly losing your job can be much less stressful if you have cash tucked away to keep the lights on.

For those who already have high-interest-rate debt, an emergency fund can also help you avoid additional high-cost financing.

Here are the key steps to setting up an emergency fund.

Step 1 - Define your savings goal

Three- to six-months' of your current salary is a typical estimate of the ideal emergency fund size. That's a decent starting point, but it sounds daunting to those just getting their financial footing.

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 and 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.

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 savings accounts

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 2.25 per cent to 1 per cent.

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 six months. 

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 pay, 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 buy a coffee for $3.50, $1.50 will automatically go into you savings account. If 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?

A version of this article appeared on Morningstar.com.au in September 2018

is editorial manager for Morningstar Australia. You can follow her on Twitter @rap_reports

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