People who spend most of their payday money within a few days risk uncertainty and having to borrow money from friends and family if they suddenly need to pay medical fees, need urgent repairs to their car or lose their job and a few weeks later don’t have enough money for the next rent or mortgage payment.
One of the topics I’m keenly interested in is financial literacy and how people behave when dealing with money. Recent research by the Australian Federal Government into changing behaviour (PDF) revealed that:
“Most people heavily discount future costs or benefits compared to immediate costs or benefits. The further into the future the costs and benefits are likely to occur the more they are discounted. This is a key tendency in helping to explain the difficulties people experience in making lifestyle changes where benefits are longer-term”.
This applies to making the decision to start saving some money in a separate account for emergencies as much as it does to other big decisions like whether to quit smoking or binge drinking.
“Temporal discounting is our tendency to want things now rather than later. In order to encourage us to save money, banks have to offer us a reward in the form of an interest rate. In order to delay gratification, we have to be convinced that the reward in the future is going to be sufficiently large to compensate us for going without right now.” – I Want it Now!Temporal Discounting in the Primate Brain
Setting Up an Emergency “Rainy Day” Fund
A good place to start would be to setup an emergency fund of at least $1000.
Call it a slush fund, self insurance or a rainy day fund, having one can mean the difference between the comfort of knowing you can pay an unexpected cost or the constant nagging fear that you’re one bill shock away from disaster.
Mortgage Offset Account For Emergencies?
The chair of the Federal Government’s Financial Literacy Board Paul Clitheroe is a frequent guest on the ABC Local Radio Nightlife program and he often discusses how a home loan mortgage is a great form of forced savings, which compels people otherwise reluctant to save money, to do so by having to make regular mortgage repayments.
I agree but suggest that an emergency fund should be separate from your mortgage because otherwise instead of paying the mortgage debt off steadily over time you’ll be lured into using previous mortgage repayments as a piggybank to draw from for unexpected expenses.
Encouraging Your Kids To Setup An Emergency Fund
If you’re a parent you my have the nagging suspicion that your grown up 20-something year old kids (also known as “kidults”) think of you as their emergency fund in case dire financial circumstances befall them.
The concept which explains this behaviour is called moral hazard which means that “people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for”.
If your kids know that you’ll bail them out if they rack up a $1000 mobile phone bill, how do you think they’ll act when making mobile phone calls?
Evidently it’s in both their and your best interests to encourage them to setup a rainy day fund, so they build up a savings habit and don’t hit you up for “bailout money” at regular intervals.
Kickstart An Emergency Fund
One of the best ways to save money from your pay is to whisk it away from your transaction account before you get the chance to spend it.
Choose a small amount you won’t miss like $50/week and setup an automatic savings plan so the money gets withdrawn from your transaction account on pay day into a high interest savings account. After a year that adds up to $2600 plus interest.
Do you “live for today” or “save for tomorrow”? What do you think about the idea of having an emergency fund?