“Rainy day fund”, “emergency fund”, “money under the mattress” – call it what you will, but most of you will need a stash of cash at some stage in the future – for when ‘life’ happens.
The rationale for having this pool of cash is not complex. There will be times in your life when tough things happen. Things break, people get sick and income dries up. If you don’t have adequate insurance to protect yourself, you might find yourself in a predicament. That’s all an emergency fund is really; insuring yourself against the financial effects of unforeseen events. Think of it as self-insurance.
As with all insurance, it’s about considering the risks and taking the appropriate action. The risk is that given your existing income streams and cash resources, an expense occurs for which you’re unable to provide. These are not the expenses you so diligently tracked. These are the kind of things that could one day happen, but for which you don’t and can’t factor into your financial plan.
Practically speaking, an emergency fund generally takes the form of a pile of cash or cash equivalent. Let’s start with “how much”, and soon we’ll explore “where”.
Given the uncertainty around what might happen, how do we know how much to stash away? Too little and it defeats the purpose, too much and well…we’ll get to that soon.
The prevailing wisdom is to start with a multiple of the sum of your monthly expenses – let’s say three times. These are the expenses that you previously tracked. A list of everything you are obliged to pay every month – to survive. For the purposes of this article, let’s assume that every month you need to spend R20, 000 on expenses.
The starting balance for your desired emergency fund is therefore R60, 000 (R20, 000 x 3). Should you become unemployed, you would have enough cash to survive for three months, after which you’d need to find a new job, or a new source of cash.
Once you’ve got your figure for (expenses x 3), you can adjust up or down for the following situations.
The financial consequences might not be that dire if your partner is still earning an income. Chances are you might still be able to settle a large portion of your monthly costs with your partner’s income. If you’re single or in a couple but with a partner who does not work or does not earn nearly as much as you do, losing your salary becomes a bigger challenge.
There is perhaps a smaller likelihood of you losing your job or not being able to find new employment relatively quickly, in which case your situation might not warrant holding many months’ worth of cash.
Any illness or injury that results in you being unable to work and generate income is a problem. If you do not have the benefit of paid sick leave in terms of a formal employment contract, you might then consider holding more cash. A salaried employee might enjoy 30 days’ paid sick leave over a three year period and need not worry about this loss of income.
If you earn income from rental, fees, or an alternative salary, then the potential impact for a loss of a salary would be less harmful than for someone who relied entirely on one salary from one employer.
Consider holding more cash if you can’t think of a lot of places in which you could cut costs. You’re less financially agile, and so should have a larger emergency fund.
Do you own anything or are your responsible for anything that could potentially throw you some curveballs? Owning a residential property would like pose a higher risk in terms of things that could go wrong, as opposed to someone who rents and who would rely on the lessor to attend to costs. A small business owner might be required to inject some cash into their business from time to time to keep things running – is this a possibility for you?
Being financially responsible for more people brings with it an increased probability for something to go wrong. Consider a sole bread-winner in a family of four. This brings with it a far larger opportunity for an emergency to arise, when compared to a single earner who does not have any dependents.
We joke, but also recommend taking into account your personal chances of experiencing a once-off emergency based on the reliability of your car, your resistance or lack of resistance to illness, and if you own property in an area prone to floods, fires, or Godzilla.
Using a period of months is convenient because it relates your potential inability to settle a cost or series of costs back to your expenses every month, and therefore covers the potentially dire scenario of a total loss of income for an extended period of time. This could be through ill health, loss of employment or being forced to take unpaid leave.
Here are two examples to help you figure out how you might arrive at your own emergency fund value.
Michelle considers her employment from a reputable and stable employer to be relatively sound. She is unmarried but lives with her boyfriend in a rented flat. Neither of them have any dependents. Their combined monthly expenses total R20, 000. Michelle generally shares the monthly expenses 50/50 with her boyfriend. Perhaps he’s a particularly good musician.
Michelle considers three months’ of expenses (R10, 000 x 3) as a starting point and considers making adjustments accordingly.
She is confident that her job is secure and feels no need to increase her amount in relation to her employment. As she rents, should anything go wrong she is happy that the lessor would attend to the problem. She has suitable medical insurance in the form of medical aid, such that it unlikely that she’d ever be out of pocket for any large medical costs. In absolute terms, she feels that R30, 000 is enough also to cover any emergency repairs that may arise on her car, given that it is only two years old and covered under a motor plan and manufacturer’s warranty.
She decides that R30, 000 is an appropriate amount to set aside for her emergency fund, which buys her three months of contributing to her monthly expenses.
Dave is married and the father of two. His wife is a stay-at-home mom and he is the sole breadwinner. Dave’s monthly expenses total R35, 000. David has a good job and feels relatively stable in his position, but Dave is also no fool. Cut-backs and retrenchments are always a possibility in his industry. Dave has no other people who rely on him financially.
Dave considers three months’ of expenses (R35, 000 x 3) as a starting point and adjusts his amount accordingly.
Dave realises that if he loses his job, despite how good he thinks he is at widget making, his family will face a mammoth challenge. There are no other income streams to help pay the bills, as his wife doesn’t work. Dave runs some numbers and reckons he could reduce his monthly expenses by about R5, 000 if things got dire by cutting out some ‘nice-to-haves’. Dave acknowledges that his house is ageing and its maintenance has largely been ignored. It would not surprise him if the entire house needed to re-wired and the geyser replaced.
Dave arrives at a number of six times his monthly expenses. He takes the R35, 000 and reduces it by the R5, 000. This scaled-back monthly expense multiple totals R180, 000. Dave also considers this number enough to take care of any unforeseen disasters that his house might throw at him.
Just as importantly, six months’ worth of expenses is a number that allows Dave to sleep at night. Only Dave knows this number, and for Dave, having six months’ worth of expenses helps him to gain a huge amount of comfort, partly because for Dave, his relationship with money is largely one of a source of security.
As tempting as it may seem, saving two years’ worth of expenses in your emergency fund is probably not the best idea. An emergency fund can get too big. This does not mean that your justification for such a sum is necessarily incorrect, but it comes at a cost – the opportunity cost of a meaningful return on your money.
We will shortly talk about the returns on your emergency fund and as you will soon see, they aren’t likely to be great. Choosing to have too much of your wealth tied up in cash may not be a good thing, especially if you are sacrificing the potential for a greater return in favour of a capital guarantee in the form of cash. But don’t worry about this now; we’ll deal with this shortly.
How much you ultimately choose is entirely up to you. Arrive at a number and then play through some scenarios:
How does your sum saved thwart the financial effects of your emergency?
Something that you might experience as you apply your fledgling consciousness to your finances is that you start to understand your expenses better and may be in a better position to appreciate where your emergencies may arise. You may see new, previously unconsidered risks, or realise that you might be holding onto too much cash.
As life changes and your financial responsibilities change, your emergency fund will need to grow or shrink in response. Having children, buying a house or anything in general that adds to your financial exposure may require a response in terms of boosting your balance. Scaling back and having dependents find their wings could likely free up some cash.
Unless you’re putting out a house fire with shiraz, no.
But what should you use it for?
Not being able to pay for something without using a credit card and for something that is needed then and there, is an acceptable reason for using your emergency fund.
Events that arise based on outside factors could qualify. You don’t choose for your car to break down or for your son to break his ankle, but you choose to renovate your house or go on a holiday. Chances are that if you can choose it, the cash required to pay for it is better found in your financial plan.
Just because your TV breaks and you’d have to use a credit card to replace it, does not make it an emergency, as not having a TV is unlikely to affect your ability to survive. Also, remember that anything that affects your income is affecting your ability to survive. That’s why a car implosion could be an emergency.
A ‘complete’ emergency fund is not accumulated quickly unless you have idle cash elsewhere you can use. If you conclude on a four month emergency fund, it could take you a considerable amount of time to gather that amount of money – and that’s okay. It is not uncommon for someone to take a year or two to gather that sort of cash – don’t be disheartened.
How you choose exactly to find the cash to build your emergency fund is up to you. If you don’t have an emergency fund, we’d encourage you to add it to your list of goals. Consider your monthly difference and see what can be allocated to saving. If your monthly difference is negative, you should probably not be focusing on building an emergency fund yet unless you can meet your financial obligations as they fall due.
As we said previously, some people have a negative monthly difference in the short term, but over the medium to long term, they still earn more than they spend. Our cautionary is to those people who have debit orders fail or who borrow every month to make ends meet. If this is where you find yourself, you need to prioritise these immediate needs.
Lastly, some people may feel that accumulating an emergency fund is not appropriate for someone who has debt. They’re not talking about people who cannot pay their bills on time, they’re referring to people who have vehicle finance and credit card balances. Possibly even a mortgage. We disagree with this approach and will explain why in several articles’ time.
It may also be that these people advocate the use of existing lines of credit to act as an emergency fund of sorts; using your credit card or drawing down on your bond equity in times of need. We don’t agree with this either and fortunately you need only wait for two more articles to learn why.
The “how to” is better approached along with the “where” so be sure to read our next few articles. It will be simple enough though: cash in a bank account, money in a unit trust, a debit order into a savings product. It will all be simple.
As an aside…
As you now progress into the third stage in this Foundations series of articles, we feel like it’s a good time to state a few truths and set the stage for the months ahead. The ‘spoiler alert’ for personal finance if you will.
Let us start by saying that personal finance is not about the right way, the best unit trust, or the most effective budgeting strategy. As you will come to see, many financial products are largely substitutes for each other, so it’s less important to find the best one (if it exists) and more important to find one at all.
This is precisely why we try very hard to convey concepts and ideas in our articles and spend a relatively small amount of time explaining how to actually accomplish something or see it through.
Personal finance done right is about doing something, going about it the wrong way is doing nothing at all and expecting things to change. Then you’re being nothing more than an ‘evasive’.
Convincing yourself that there can be only one way to do something right will waste hours of your time (as will be explained comprehensively in the months to come). Personal finance is about bettering yourself, learning skills and accepting accountability for your financial future, so that it doesn’t become something that consumes you later in life for all the wrong reasons.
Our articles up until now have largely been dealing with the more philosophical side to money. Now, we’re going to start suggesting you do certain things, things that involve doing a bit of research, filling in forms and dealing with financial services companies.
If you’re unable to keep up or get lost along the way, don’t lose sleep. We’re not going anywhere and neither are these articles. If you have any specific questions or problems, post a comment and we’ll do our best to help out.
 There are times when you may have a very large cash balance that does not form part of your emergency fund. This may be in instances where you are saving for a particular goal that sits on your ‘short term’ horizon.