Note: This article was originally published on Zonotho, a financial education start-up, in November 2019. It came out discussions with people about the most basic personal risk management tool: the emergency fund. A few months after this was written, we had the global COVID crisis and this article became a little too relevant…
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We’ve all had that bad month. When you’re counting the hours to payday and living off the meal plan of a large squirrel and then BANG! Your car breaks down. Or a family member gets sick. Or your microwave explodes. Or all three. It’s at times like these that South Africans sigh and say: “put it on my credit card”.
Does it need to be this way?
We all know credit cards and small loans charge extortionate amounts of interest. One alternative to getting sucked into the debt trap is to keep an emergency fund.
What is an emergency fund?
‘Money for a rainy day’, ‘money under the mattress’, it goes by many names. The idea is to have money stashed away, but easily accessible, that is only used in the case of emergencies.
You can build an emergency fund by keeping aside a portion of your pay check every month. If you put it in a savings account, you can even earn interest on the money. Over time, the fund will grow until you need to use it to pay for something.
How does it work?
Let’s look at a scenario* where you have a large unexpected doctor’s bill in August, and you find out your car needs a small service in November.
Scenario 1 – Pay with the Emergency Fund
Let’s assume you’re putting money in an emergency fund every month. When the doctor’s bill comes in August, you can afford to pay it because you’ve been putting money away for eight months. When the repairs come in November, if you put away enough, you could even make it to the end of the year with money still left in the fund.
Scenario 2 – Pay with a Credit Card
Now let’s assume there’s no emergency fund (the reality for most people). When the medical bill comes in August, you either need to pay on credit or take out a loan, both of which charge high rates of interest. You pay the instalments in September and October, but when the car repairs come they push you further into debt. Your interest costs are rising quickly, and if another emergency comes, you’ll be in real trouble. This is how people find themselves in a debt trap.
Which scenario would you rather be in?
How large should your emergency fund be?
As your emergency fund grows, you’ll eventually reach a point where you’ll wonder: “How much do I need to keep to be safe?”. There are many schools of thought here.
At a minimum, consider about one month’s worth of expenses. In other words, if you lose your job, the emergency fund will be enough to cover your expenses for a full month before it runs out.
A safer target would be three months of expenses. At this level, you will be protected against a severe run of bad luck, or even losing your job and being without work for three months.
Some people may choose to keep an emergency fund even larger than this. You may need more safety if you have a mortgage, elderly parents or young children, or if you don’t have other resources you can call on in an emergency.
Insuring yourself
In the end, you can see an emergency fund as a way of insuring yourself against going into debt. The money you put away every month is your ‘premium’. And if you ever have an emergency, you make a ‘claim’ from the fund. The key difference: if you never have an emergency, the money is still yours.
Stay safe people!
*The scenario is only for illustration purposes. The actual amounts will vary from person to person.