How to hope for the best but plan for the worst
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 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.
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.
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.