Maintaining an emergency fund

An emergency fund is an amount of cash you hold that is not used for day to day transactions, but utilised instead when an unanticipated event occurs requiring money.

For example, you may need a lump sum for a vet’s bill, or you may lose an income source and daily expenses need to be met until a new income stream is found.

There are three aspects to consider when managing the emergency fund:

  • Size and location
  • Building it up and monitoring
  • Withdrawal and replenishment

Size of fund

You first need to estimate your annual non-discretionary spend, divide that number by 12 and them multiply by a target factor that helps you sleep at night. For some, this may be six months worth, for others it may be more.

The important thing is that it is intentionally sized and treated as a separate layer when managing your cash. This doesn’t necessarily mean a different account, but an identifiable number in your financial tracking.

You don’t ever tap into it for your day to day spending. It just sits there, earning some interest. You will need to regularly review it though, because it will change because of inflation and also lifestyle adjustments.

Building it up

After calculating the size of the fund, you should check your current cash balances against the four layer model.

If the cash balance doesn’t cover the first three layers completely yet, divide it up between the three in a way that suits your lifestyle (for example, if you are in precarious employment, you may wish to focus more on the emergency fund than deferred consumption).

You can then use your monthly income to top up the layers until they reach the required size. It’s usually a good idea to build the emergency fund before excess funds for investment.

Every so often, check both the size of the required emergency fund and the distribution of cash between layers to make sure they are meeting your current needs. It is not a “set and forget”.

Withdrawal and replenishment

Once you have built up the required emergency fund level, it can just sit there until the unexpected event occurs (which it surely will).

Sometimes it’s a one-off like fixing a boiler. In that case, you just top up the amount withdrawn over the next few months from your income and you are back to a stable state.

If the unexpected event is loss of income, then you can plan your withdrawal more carefully. There is no need to panic. You should pause any future investment contributions and also discretionary spend (it’s called discretionary for a reason).

This then allows you to unwind the emergency fund over the next few months while you seek new sources of income. You should not need to reduce your non-discretionary lifestyle if you resolve this before the end of the target period.

Once you get a regular income again, you can build back the layers in the same way you did initially, and once everything is back in track, resume discretionary spending and investment of excess cash.

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Disclaimer

I am not your financial adviser.

The information in this post relates to my financial journey. It may or may not be relevant to your own. You need to make your own decisions on your own financial strategy.

Do not buy or sell anything based solely on what you read.