We are told by most financial commentators to pay off our mortgages as fast as we can. It does not matter if you are a business person, salary or wage earner, you will be told the same, and in theory this is the correct advice.
However, what about building up an emergency fund ? You would have room to move in the midst of a financial crisis, or tough times, and have keep the bank or other creditors off your back.
It is usually quite easy to borrow money when we have secure jobs / normal health, but almost impossible to borrow if things are bad e.g. if we are made redundant , cannot work, are ill, or have had a bad accident.
Remember “a bank is an organization that will lend you an umbrella when the sun is shining, but they will want the umbrella back when it starts to rain.”
There can be many causes of an emergency:
Death of the family breadwinner
Death of the mother of a young family
Key staff illness or accident
Economic downturn in NZ
Poor produce prices
Rising interest rates
And some we even cannot imagine.
Dead money vs. an asset
We cover a lot of risks using life, fire, and general insurances, but the premiums are “dead” money that you don’t get back, and all too often insurances often do not cover the emergencies that arise. Most life insurances premiums increase with age, and rise very sharply from around age 55. By building up an emergency fund, you gradually eliminate the need and eventually the cost of such insurances.
Conversely your emergency fund is an asset.
How much should be in your emergency fund ?
The NZ rule of thumb is 3 months income, and it seems it is as high as 8 months in the USA
Obviously the more debt you have the more your emergency fund should have in it. However any amount is better than none and getting started is the most important step!
Liquidity (access to money)
Emergency funds need to be liquid – they must be easily accessed. There is not much point having an emergency fund unless it is readily available within say 2 weeks.
How can you build an emergency fund ?
Put aside some money when you have some, or set up an automatic payment system and put the funds in monthly.
Where not to put it
The first consideration is not in the bank where you have your mortgage. Emergency funds should be as far away from your bank manager’s control as you can get. If you miss a mortgage payment, the bank can move money from one of your accounts to another without even consulting you.
Rental property, beach houses, baches, forestry, and commercial buildings are not suitable as emergency funds either as they are not liquid. Money from these assets can take months to unlock (even years sometimes).
Nor should it be all invested in shares, since Murphy’s law says they are all too likely to be down 10%, 20% or even 30% at the time you need the money.
These assets are not suitable as emergency funds.
Where should emergency money be invested ?
Hopefully you will never need the money for an emergency, and so it should be invested, but in a conservative place. Ideally it would be invested in a conservative diversified portfolio, with a portion offshore.
If it is invested, over time it should grow, and if it is never needed, it will become part of your retirement funding.
New Zealand is a tiny economy and is not particularly well diversified. Further, the NZ economy is highly vulnerable to earthquakes, imported diseases and pests. If the NZ economy takes a big hit for one reason or another, it is likely that the NZ$ would drop sharply.
If this eventuates, the value of your offshore emergency funds would rise.
What sort of investments is recommended?
A highly diversified conservative portfolio of about 75% in bonds and 25% in shares is suitable.
The bonds should be A rated or better, and the shares in the right kind of share fund, on & offshore.
The correct diversification dramatically reduces risk too.
Bonds over many years have paid 1% to 3% better than short-term bank deposits.
Shares have had a bad patch recently but over the longer term shares have out- performed bonds by 3% to 5%.
Therefore over time returns from a correctly structured conservative portfolio over the medium to long term are likely to be about 2% pa. higher than bank rates.
It is best to ‘stick to your knitting’ and do the things that you are good at doing. Therefore, you may be better off to use an AFA (Authorized Financial Adviser) rather than trying to pick good bonds and shares yourself.