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August 07 newsletter

Emergency funds

Having access to an emergency or rainy-day fund is a fundamental financial planning strategy. It has both financial benefits and, like having insurance, a psychological benefit of well-being, because you are in true control of your personal finances.

The need for emergency funding arises for all sorts of reasons. Emergencies can range from the need to replace a hot water cylinder, to a major illness which necessitates a long period off work.

How much do you need?

The recommended industry standard is 3 months of necessary spending, which includes food, mortgage and power bills. Other spending, such as clothes and holidays, can probably be postponed for a period of time.

What if you have debt?

From a financial planning perspective, it doesn’t seem right to have $5,000 sitting in a bank account when you have a $300,000 mortgage. Holding cash seems even more unreasonable when banks are encouraging their customers to incur more debt and will happily extend credit if you need extra cash. While that is probably true, it assumes that today’s buoyant economic conditions will prevail. For example, if you suffer a long-term illness at a time when the property market is suddenly seeing some mortgagee sales, the bank may not be too keen to extend your debt. And we know the old adage – banks only want to lend us money when we don’t need it.

Perhaps, instead of having the cash, you ensure that you have access to credit that is not dependent on approval at the time of need. Examples of such credit facilities include credit cards.

What if you have investments?

Cash is likely to form part of your investment portfolio. A recommended option is to have part of that cash allocation in an on-call (no fees, high interest) account.

But I have income protection insurance

Income protection insurance is designed to protect you for a medium to long-term period of disablement. Your cover will be subject to a wait period of at least 2 weeks and, more likely, 13 weeks. In addition, most income protection payments are paid a month in arrears, so even if you have the shortest wait period of 2 weeks, you will have a 6 week cash flow problem (but, more likely, a 4 month problem).

Therefore, even if you have income protection insurance, you should still consider some form of emergency funding.

Random page of the month

Emergency funding is just one part of your financial health check up.