An emergency fund: Do I really need one?

First and foremost, I am not an accountant, nor do I provide specific financial advice. I am merely discussing my thoughts and opinions based on my own personal experiences.

Financial planners quite regularly suggest to build up an emergency fund to people who are trying to eliminate their debt. The idea is to build up an emergency fund to have extra money available in case some emergency comes up and you need to spend some money (I.e.: Car engine blows up, family member breaks an arm, etc.). While this idea has great merit, there is a lot of debate surrounding the subject as to whether it is really a viable idea or not. I think it is time to separate facts from opinions and come to a real conclusion surrounding the issue.

An emergency fund: the facts.

Here is a list of the observations I have made about creating an emergency fund based on the material I have read over the years:

The Pros:

  • Allows you to build up savings and to get into the habit of regularly contributing an amount of money to your future.
  • Is an emergency 'slush' fund to prevent you from going further into debt.
  • Can help an individual whose finances are out of control to gain confidence and build momentum.
  • Can provide a 'safety' barrier in event of extended periods of unemployment.
  • Should be built up to 3-6 months worth of wages, but should begin with a minimum of $1,000.
The Cons:
  • Money could be used to re-pay existing debt, which will reduce interest payments.
  • Money is sitting idle when it could be achieving a higher return on investment outside of a regular transaction or savings account.
  • Individuals with a tendency to spend money will be more inclined to spend the money as the amount grows within their bank account.
While there are more pros and cons, these seems to be the major points for and against. The question you need to ask yourself is "how disciplined am I?". If you are really a disciplined individual in relation to your finances then you might consider using the money you save to pay down your debt, and then redraw if necessary in an emergency. The amount on interest you save in the interim can be applied to the principle of your debt. Alternatively, you might find ways to increase the returns on your emergency fund by investing.

If you are not very disciplined, I would suggest setting up an automatic debit from your normal account into a savings account that you can only access online or with notice. This will prevent you from spending at the ATM and make it a hassle to withdraw to your transaction account to spend the money that you save. When you have the minimum amount in your savings account, you can then withdraw in the event of a real emergency. The money that you were contributing to this fund in the meantime can then be applied to repaying debt.

Personally, I don't have any debt (other than a HECS-debt) but I do have a savings account that I contribute to regularly. While the money is currently not accumulating much of a return, I am looking at options to increase my return, but in the meantime it is nice to see an account accumulating money and keeping on target with my savings goal for the year.

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