An emergency fund is a pot of money you should have available for use if an unexpected bill comes your way. This is one of the most important elements of your financial planning. Everyone should have an emergency fund, but most people do not have enough put aside. If you need cash in an emergency, and this is not available, you might compromise your financial plans. At best, this will put back your plans; at worst this could cause significant financial harm.
What is an emergency fund?
An emergency fund is simply a pot of cash put aside for use in emergencies.
The sole purpose of this emergency fund is to be available should something change in your life dramatically, and quickly. You should be able to easily access your money to plug a short-term gap without resorting to other long-term savings, or borrowing.
You should set up a separate instant access bank account for this emergency fund, put the appropriate amount of savings aside, and forget about this money until it is needed. After that just review the fund regularly to check you still have the appropriate amount saved. We do not recommend that you worry about the interest rate on this part of your savings; the most important thing to remember is that your emergency fund is just there to solve any short-term financial situations.
What your emergency fund is not for
Your emergency fund should be to provide short-term cash for unexpected costs. Your emergency fund is not to be merged with your short-term planned spending. If you have savings for these projects, do not include these savings in your calculations as you will be tempted to think you are in a stronger position than you really are.
If you use your savings for your planned expenditure in emergencies, you will solve your immediate problem by raiding other savings for a more urgent issue. That less urgent planned expenditure will still happen, so by accessing this money you are only really putting off the inevitable.
Why might you need access to an emergency fund?
Your emergency fund is there to provide short-term funds when something unexpected happens. The emergency fund is not designed to solve longer-term issues like sickness, or retirement.
Look at the situations below and honestly answer whether your current savings would be enough to cope with any of these events.
1. An unexpected bill
The most likely need for an emergency fund is an unexpected bill. Perhaps your boiler or car needs to be repaired, or you need to source an alternative. Perhaps you find yourself needing to cover a bill that is not insured. The list could be endless, but if you think back over the last 5-10 years you can probably remember a variety of situations where having a pot of cash to cover this short-term need would have been very welcome.
2. Losing your job
If you lose your job for any reason, you will lose your income. Your income drives your lifestyle expenses, and without this money coming in you will quickly run out of disposable income. Without this money, you will have to start making decisions about your future spending.
An emergency fund will allow you to put off these choices while you look for a new job.
3. Unexpected illness or death
If you are ill for an extended period, you might end up losing your job. At the very least, your income is likely to reduce due to sickness benefits, or state support. The death of a family breadwinner can have equally difficult short-term financial consequences. Even if you have insurance in place, there may be a delay in securing a payout, and assets may be inaccessible while probate is resolved.
An emergency fund will allow you to deal with the unexpected loss of income that results from these situations.
How large should your emergency fund be?
As a general rule you should aim to put aside enough money to cover 3-6 months of household expenditure in an instant access account. Additional planned expenditure (such as tax, holidays, and projects) should be added to this figure, and separate. If you are cautious (perhaps you are retired) then you may want to put aside more money, but be careful not to have too much in cash as this will lose its value over time.
This amount should be reviewed regularly, perhaps annually, as your situation changes.
If you have guaranteed income, you may need less in your emergency fund. To some extent, the final decision on the amount of cash to hold is a judgement.
How to build an emergency fund
It can feel daunting to build a suitable emergency fund, but here are some basic tips:
- Start a regular savings plan
Set up a separate bank account, away from your current account that pays your bills. If you set up a standing order from your current account to your savings account to be deducted the day after you get paid you won’t miss the money. If your budget is tight then start with small amounts. You can easily increase the monthly savings as you spend less, earn more, or finish paying off expenditure items. You will be surprised how quickly the savings will build up, and keeping the fund separate from your normal spending should mean you are less tempted to access the money without due attention.
We can help you to balance your short-term needs and your long-term financial plans. This balance always includes a recommendation for a sensible emergency fund, but we will also help you to put any excess cash to work for your long term financial security. If you would like a complimentary review speak with an expert today.
