Investing basics: Building a realistic emergency fund


Jason Prowd  |  29 October 2018  |  6 min read

Key Points
  • How much money do you really need in your rainy day fund? It might not be what you think.
  • Maximise your emergency fund with a high-interest savings account.
  • Automate payments for effective, effortless saving.

Film director Alfred Hitchcock was a master of anticipation, saying it was always worse than the actual horrors. But maybe he wasn’t thinking of the financial horrors that loom large in our lives. Bills stack up, illness strikes, accidents happen. And when things get rocky, we’ve rarely anticipated it, and we’re not always as prepared as we could and should be. But one way to make emergencies a sliver more bearable is to build a sensible emergency fund.

When disaster strikes, the last thing you want to be worrying about is money. Unfortunately, money worries often compound the stresses that come with emergencies—not everyone is equipped with the recommended three-to-six months salary that’s so often quoted in personal finance literature. So let’s strip it down: how can you build a sizeable emergency fund?

Step 1 – How much do you actually need?

Three-to-six months of your salary is a daunting number. Don’t get me wrong—it’s a good goal and something to work towards, but to get your fund off the ground, let’s look at the essentials. We’re talking about recurring costs like:

  • housing (rent/mortgage)
  • utilities
  • transport
  • food
  • insurance
  • high-interest debt, like loans and credit cards.

What you don’t need to account for are things like Netflix, coffees, the dreaded avocado toast (emergencies are bleak, indeed).

Once you’ve got those living expenses added up, multiply that number by three. Congratulations—you’ve arrived at your minimum savings target.

Step 2 – What else can you contribute?

The great thing about this method is that you’ve got $$$ left over—the numbers that make up your net worth. These are the funds you’ll find stashed in your savings and checking accounts. Of course, a lot of this will already be assigned to goals, such as buying a home or car. The remaining money is money that could be an extra windfall into your emergency account. And once it’s there, you’ll have that extra cushion of security.

Step 3 – Invest carefully

This isn’t the time to pursue high-risk, high return investments. But at the same time, burying your cash in an everyday banking account isn’t going to do you many favours.

You also need to be able to access this money quickly and easily, and not worry about incurring taxes or penalties.

You can do this by keeping your money in a low-fee, high-interest savings account, which could bear anywhere from 1 to 3+% of interest annually. It’s also worthwhile talking to your bank to see if you can get a bonus introductory rate. Even an extra percentage point could make a huge difference, and your money will work harder for you as a result.

Step 4 – Automate your deposits

Sometimes it takes tricking yourself to get the most out of your savings. For example, you can set automatic transfers to deposit directly into your emergency fund. Even if this is as little as $10 a week, that’s an additional $520 in your emergency fund in the space of a year. Double that and you’ve got $1,040. And if you set it to transfer when you get paid, you won’t even notice it’s gone. Much easier than tallying up how many coffees you need to sacrifice.

Reaching your emergency savings goal is the first weight off your shoulders, and these practical steps will get you well on your way there. And maybe Hitchcock was right about one thing: done right, anticipation can be more powerful than the event itself. 

author

Jason Prowd leads Morningstar Next: ready-made investment portfolios.


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