How Vital Is An Emergency Fund?

Why You Need One, How Much You Need, Where to Keep It.

Why Do You Need An Emergency Fund?

Things happen out of the blue. And they usually cost money. If you don’t have an emergency fund of between three to six months worth of basic living expenses, you’re living on the edge. For the average household, I would say between £3000 and £6000.

Emergency funds are an absolute necessity for financial security because they give you funds to fall back on if you become ill or disabled and can't work, or if you or your spouse lose your job, incur large medical bills, or have an unexpected large bill such as a major car or home repair. You know how long the NHS waiting list is!

Without an emergency fund, you may be forced to incur credit card debt that could take you many years to pay off and end up costing you much more in the long run.

You never want to be in the position where you have to buy daily necessities like food, transportation, and housing on credit. Imagine still making payments on groceries you bought (and ate) three years ago, at 10-18% interest. Pretty depressing!

Where Do You Keep Your Emergency Fund?

Emergency cash needs to be liquid. This means that it’s easily accessible – without cost, delay, risk, or penalty. Liquidity refers to how quickly an asset can be converted into cash. Your house is not a liquid asset because it could take months to sell it. Shares are somewhat more liquid than property, but you can lose money on shares if you're forced to sell at a time when the market for your stock is less than favourable. Even though interest on liquid investments may barely keep up with inflation, the lower risk is worth the lower return when you may need the money quickly.

There’s no time like the present to get started. None of us have the ability to foresee the future or predict the hurdles which lie ahead of us. This makes building an emergency fund a financial priority.

People who are living on a lean-and-mean budget will have the toughest time setting aside money for emergencies. If it’s possible to squeeze out another £20 or £30 each month and put it in a high interest savings account, it’s worth doing. Just make sure that it has instant access. I personally use an instant access ISA.

Saving your money in a small account for emergencies is definitely a better alternative to taking a loan or cashing in your long-term investments. If you take a loan, there is the additional burden of paying interest. Encashment of your investments before maturity means not only will you lose out the interest, but also some part of the original investment. This will also set you back significantly in your overall financial plan.

I like the idea of treating the emergency fund as a bill, put the money away and don’t be tempted to spend it on the latest luxuries. Success at building an emergency fund depends on consistency of saving money on a regular basis and keeping this money separate from the general savings account. Otherwise you will be tempted to dip into this money even if you simply run over your budget at a certain point.

How Much Do You Need In Your Emergency Fund?

The minimum amount in your emergency fund should be three to six months worth of basic living expenses. Singles who don't have dependents who rely on them may be able to get by with three months' worth, but couples or anyone with dependents should definitely shoot for six months worth. The more people you support, the more likely you are to have unexpected or unplanned costs.

If you don't have short or long-term disability insurance that will pay a portion of your salary if you're unable to work, it's a good idea to have more than the minimum in your emergency fund.

Your goal should also take into account the degree of difficulty you'd have in finding a new job if you lost yours. For example, if you're a nurse and nurses are in demand, you probably wouldn't be unemployed for as long as a wildlife rehabilitator or someone with skills that are not in as great demand, so wouldn't need to fall back on your emergency fund for as long.

It's best to keep your emergency funds separate from a savings account that you use for large planned purposes, like holidays, home improvements, a wedding or new car. Keeping it separate makes it easier to leave it alone.

What Happens When You Spend It?

After you use your emergency cash, you’ll need to rebuild the emergency fund as quickly as possible. Remember how nice it was to have some funds on hand, and start on the task of rebuilding those funds. You never know when the next crisis will come up.

Remember, no cheating – don’t use the emergency cash for non-emergencies (like TVs, home improvements, or holidays). You should have separate savings account for those other goals.

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