How to hope for the best but plan for the worst

Money Magazine Australia - - COVER STORY -

The prob­lem with un­ex­pected ex­penses is that we don’t ex­pect them … or, more ac­cu­rately, we ex­pect them to hap­pen to other peo­ple, just not us. Whether that is some­thing as small as need­ing to re­place wash­ers on the kitchen tap, or the fridge we’ve had for years fi­nally packs it in, or we need to fork out cash to cover the ex­cess on a car in­sur­ance claim, the is­sue re­mains the same. If we don’t ex­pect it to hap­pen to us, we tend not to set money aside.

This is where we tell our clients to “plan for the worst and hope for the best”. When it comes to un­ex­pected ex­penses, we want them to as­sume it might hap­pen to them and build an emer­gency fund just in case – then hope they never need to use it.

What types of un­ex­pected ex­penses could you find your­self need­ing to cover?

There is no point pre­par­ing for some­thing that doesn’t ap­ply to you, or for an item you wouldn’t re­place if you lost it. So you should only be look­ing at the types of “re­al­is­tic un­ex­pected ex­penses” that could ap­ply to you. Then ask your­self, “What would hap­pen if ... the car broke down or a ma­jor kitchen ap­pli­ance broke? Or at the other end of the sever­ity scale ... if I got in­jured or sick or lost my job?” If the an­swer to the ques­tion is “I’d go with­out or just wait un­til I saved up enough to re­place or fix the lost item”, then you ob­vi­ously don’t need to do much about it. But if the an­swer is “I’m not sure what I’d do be­cause it would cost more than I have avail­able”, then it’s time to start build­ing your un­ex­pected ex­penses, aka your emer­gency fund.

So how much should I have in my emer­gency fund?

An emer­gency fund is just what it sounds like – a “fund” (usu­ally a bank ac­count) that can be ac­cessed quickly and at no or very low cost, which has enough money in it to cover most likely emer­gen­cies.

At the ab­so­lute min­i­mum you’d have a cou­ple of hun­dred dol­lars in there, and at the max­i­mum you could be look­ing at any­thing up to six months or even two years of your in­come (in case you aren’t el­i­gi­ble for in­sur­ances such as in­come pro­tec­tion, or if you don’t have these in­sur­ances in place).

With our clients we tend to rec­om­mend some­where be­tween two and three months’ worth of take-home in­come (based on the high­est in­come earner). This is be­cause the “un­ex­pected ex­pense” that we be­lieve needs to be pre­pared for – in case of emer­gency – is in­come that needs to be re­placed be­cause of time off work due to in­jury or ill­ness.

The added ben­e­fit of hav­ing two to three months’ in­come stored up in an emer­gency fund is that it could also be used in the case of other less fi­nan­cially de­struc­tive sce­nar­ios, such as ex­cess pay­ments on car or home in­sur­ances, or to re­place lost or dam­aged items.

Typ­i­cally, most Aussies either haven’t built up an emer­gency fund yet so they need to look

The fridge blows up ... one of the kids prangs the car ... you need some se­ri­ous den­tal work. We hope it won’t hap­pen but an emer­gency fund can ease the fi­nan­cial pain if it does.

at other op­tions if us­ing their own sav­ings isn’t an op­tion.

What to do if you don’t have cash avail­able?

That will de­pend on the op­tions that are avail­able to you in your cur­rent sit­u­a­tion. They could in­clude:

Re­draw­ing from loans

If you’ve been able to make ad­di­tional re­pay­ments into a vari­able rate loan, you may be able to re­draw some of these funds. The rule of thumb is that you can get out what­ever ex­tra you’ve put in, less the amount of your next re­pay­ment. A word of cau­tion: you may not be able to ac­cess these ad­di­tional re­pay­ments in fixed loans, and re­draw­ing on your loan may also change your min­i­mum re­pay­ment.

Credit cards

Credit cards are the most com­monly used short­term emer­gency op­tion. But this could be one of the worst op­tions. That’s be­cause if you don’t have the abil­ity to pay off the clos­ing balance in full on the due date you’ll pay in­ter­est on the full amount of the emer­gency ex­pense (plus other pur­chases made on the card) from day one. In­ter­est rates for cash on credit cards are usu­ally greater than 20%, which means you could be look­ing at a large in­ter­est bill.

“In­ter­est-free” cards

An­other op­tion is to make the re­place­ment pur­chase us­ing an “in­ter­est-free” op­tion, which most big re­tail­ers pro­vide these days. These op­tions are still, in ef­fect, credit cards even though they pro­vide an in­ter­est-free pe­riod. The trap here is that the min­i­mum re­pay­ment of­ten isn’t enough to clear the balance over the term of the re­pay­ment pe­riod, and at the end you’ll be hit with in­ter­est as high as 29%. The way these in­ter­est-free cards make money is by con­vinc­ing you to use the card again to make an­other pur­chase but us­ing a dif­fer­ent re­pay­ment plan – the switch be­tween “with monthly pay­ments” and “with no pay­ments” op­tions. Any re­pay­ments you make are al­most al­ways counted to­wards your “with monthly pay­ments” pur­chase first. This means that even if you have a larger amount of money ow­ing on the “with no pay­ments” op­tion, your pay­ments have to count to­wards the “with monthly pay­ments” type. This is where the trap is, be­cause the stores want you to get to the end of the longer, larger in­ter­est-free pe­riod with a large balance to re­pay (typ­i­cally these are the big­ger pur­chases be­cause they are the ones with longer in­ter­est-free pe­ri­ods – some­times up to 60 months) be­cause in­ter­est pay­ments on these amounts can be ex­or­bi­tant.

Buy now, pay later (After­pay, Zip Pay)

These ser­vices of­fer quick and pain­less ac­cess to pur­chases with re­pay­ments di­vided into a num­ber of in­stal­ments over a shorter time frame. The pit­falls of these ser­vices are late fees for miss­ing your sched­uled re­pay­ments, pay­ment pro­cess­ing fees and even monthly ac­count-keep­ing fees.

Mi­cro­fi­nance

For peo­ple on low in­come, the No In­ter­est Loan Scheme (NILS) run by Good Shep­herd Mi­cro­fi­nance can pro­vide them with a trans­par­ent, safe, fair and af­ford­able loan up to $1500 for es­sen­tial goods and ser­vices such as fridges, wash­ing ma­chines or med­i­cal pro­ce­dures. Re­pay­ments are set out over 12 to 18 months but these op­tions are much harder to ac­cess due to strict el­i­gi­bil­ity cri­te­ria.

What is the best op­tion if you don’t have an emer­gency fund?

The key to us­ing any sort of bor­rowed money (which all these op­tions are, in ef­fect) is to truly un­der­stand what you are sign­ing up for. The terms and con­di­tions are of­ten so con­fus­ing that most of us just sign up and move on with­out re­ally know­ing what we’re sign­ing up for. Once you’ve un­der­stood what you’re com­mit­ting your­self to, the most im­por­tant and help­ful thing you can do is to set your­self a plan that states how you are go­ing to pay off the loan as fast as pos­si­ble, giv­ing you the best chance of not pay­ing any in­ter­est or keep­ing those in­ter­est pay­ments to an ab­so­lute min­i­mum.

Steve Craw­ford is CEO and se­nior wealth ad­viser at Ex­pe­ri­ence Wealth.

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