Today we are going to talk about the importance of building and maintaining an emergency fund.
This topic is one of the first steps you must take in order to stop living from pay check to pay check. The first being to eliminate and escape debt – if you are in debt you need to plug the hole in your sinking ship before anything else!
What is an Emergency Fund?
Simply put – an emergency fund is a bank account that contains a sum of money that has been set aside for only emergencies.
Your emergency fund should only be used as a last resort. Do not fall into a habit of using your emergency fund as an overflow account for bad habits!
Lets use three examples:
No Emergency Fund
Bill has no emergency fund. He lives each month pay check to pay check and does not account for anything going wrong. In Bill’s case when an emergency appears he does not have the money to cover the issue. At this point he has very few options. Cut costs from other areas of his life to cover the emergency or borrow the money from someone.
Unfortunately the above example is more normal than you would think. According to Open Money – in conjunction with YouGov – 1 in 5 adults within the UK do not have any immediate accessible savings.
In the US things are not much better – with only 41% of people able to cover an emergency with savings. More worryingly is the methods that people are having to undertake in order to cover these emergency costs! Of those surveyed, 20% of people were required to gain additional financing that they would need to pay off over a period of time.
With the current average credit card APR (Annual Percentage Rate – the interest you pay on top of the amount you borrow) at 22.5% these people will pay a premium in order to just survive. In some cases – these bills can mount up and the interest will compound causing significant financial pressure on individuals.
If you take one thing from this article… BUILD AN EMERGENCY FUND.
The Overflow Fund
Mary has £500 within her main bank account. She also has £1000 within her emergency fund. She has already paid all of her monthly expenses from her salary. Mary wants to book a holiday that will cost £1000 but she knows she will need to borrow £500 from her emergency fund. She decides to go ahead and book the holiday – leaving £500 left in her emergency fund.
Of course the above example is how not to use your emergency fund.
Mary has now left herself in a fragile financial position (she was already at risk before she did this!). What happens if Mary needs to repair her car, receives a fine, her boiler breaks or even worse – she loses her job!
I am fairly certain Mary will regret purchasing that flash holiday!
Of course, you won’t know what hit you until it happens!
The True Emergency Fund
Jack has £500 within his main bank account. He also has £6000 within a separate easy access bank account to his main account. This emergency fund has been placed within the highest interest rate account that he has been able to find on the market through comparison sites.
This month Jack has found that he needs to replace his boiler and repair his car from a sudden breakdown. The following items have caused an emergency situation where Jack will be required to pay £1500 in order to get to and from work and keep his heating on!
Fortunately Jack has ensured that he has built an emergency fund that he has set aside for just this scenario. He will not have to borrow any money from anyone and he will still have a significant pot that he can call upon – if further emergencies arise.
Jack does not stop there! He then refills his emergency fund with his pay packets over the following months before continuing his journey to financial freedom and wealth!
Be more like Jack!
How much do you need?
In general you should aim to set aside 3 to 6 months worth of expenses. If you don’t currently know your average monthly expenses first you need to calculate this number.
Where you sit within this range will be heavily dependent on your current circumstances. Ask yourself the following questions:
- How secure is your current employment?
- How many dependents do you currently have? These are the number of people that depend on you financially.
- Do you have a high level of disposable income? This is the money you have left after expenses.
- Do you have a stable income?
If you are concerned with any of your answers – err on the side of caution and shoot for 6 months.
As always the following is a guideline and not an exact science. You should always consider your own circumstances – but always aim for a minimum of 3 months worth of expenses.
To provide an example I will use the average UK house hold monthly expenses of £2538 a month. This is based upon the average household size of 2.4 people – so only use this as a guide – you will need to work out your expenses!
3 months: £7614
6 months: £15,228
Again bare in mind that this is average and you may require less or more than this dependent on your expenses and circumstances.
Can you have too much in your emergency fund?
Like anything in life there is always an opportunity cost (trade off) of any decision you make.
In this case the money you set aside within your emergency fund will be “sitting on the side lines” so to speak. The money will not be invested in appreciating and income generating assets. Meaning you will lose out on any compound interest or capital appreciation by having the emergency fund.
Secondly you will be at the mercy of inflation. You will need to be able to access the money easily in an emergency. The other opportunity cost here is the fact that easy access savings accounts will often offer poor interest rates. With the average easy access interest rate running at 0.22% – you will lose buying power on your money year on year.
Not good.
Does this mean you shouldn’t have an emergency fund?
The short answer…. no.
If you have no liquid (easy access) cash and an emergency arises you will face the same problems that Bill faced in our case study above!
Furthermore, if you are not willing to borrow the money to cover the emergency you will have to sell assets (if you have them in the first place!). This could be at a time of poor market conditions or may require you to take money from your tax efficient ISAs (remember you only get your ISA allowance once per year – so it is best left alone to grow).
You need to find the right balance. Firstly work on the fundamentals.
- Are you debt free?
- Do you have an emergency fund covering 3 to 6 months your expenses?
Until you can say yes to both of these questions – let’s resolve these items first! Then we can worry about beating inflation and wealth creation.
Build a strong foundation first. You will thank me later.
How do I build an emergency fund?
First things first you will need to open a separate easy access account with your bank. With online banking this is relatively easy and can be carried out very quickly with your current provider. I would recommend before you do this you check for the best interest rate accounts on the market with a comparison site. See how your current provider stacks up – and if needed – switch providers.
Do this now.
Now you have set up your second bank account you have two options based upon your current circumstances.
Deposit a lump sum equal to 3 to 6 months your expenses. Job done.
Unfortunately most people will not be able to spare this much money straight out the gate. If this is you then do the following.
Build your emergency fund overtime
Before your next pay check, set up an automated payment into your new emergency fund account. If you are debt free, the more money the better at this stage.
You can set up a standing order with your bank provider. A standing order is an action to your bank provider to transfer a set amount of money to another account. You will be able to find this action within your online bank account or contact your bank to set this up.
The best part about a standing order is once you have set this up you don’t have to think about it. Automate your finances and you will boost your success and free up your time for other activities!
Before you decide the amount, work out how much money you will have left over after all of your monthly expenses. If you are unable to spare the money you will need to cut down on your expenses or increase your income.
Next, based on the amount you have chosen, divide this number by the total emergency fund figure (3 to 6 months your monthly expenses). This is the total number of months required to hit your target.
Not happy – increase the standing order amount.
If you have any money left over at the end of the month – transfer this to your emergency fund.
Wait the number of months from your above answer and cancel the standing order. If an emergency arises and you withdraw funds from your new account – remember to refill the account by carrying out the process again or depositing a lump sum.
And whatever you do…
DO NOT TOUCH YOUR EMERGENCY FUND UNLESS IT IS AN EMERGENCY!
I have an emergency now – what do I do?
Don’t panic.
Life is bound to throw you some curve balls and if you have not started your journey to financial stability yet there are some options. Once you have overcome your present issue start to build your emergency fund so this never happens again!
- Cut back on expenses – first and foremost if you have an emergency and no liquid funds you should cut back on expenses for the month where ever possible. This will free up money to pay for the emergency.
- Borrow from friends and family – pay them back the following month or instalments over several months.
- Insurance – this is not something you can carryout during the issue. However taking out the correct insurance on items that are usual problem areas is always a wise decision (car, house, contents, life).
- Credit Card – Another option is to put the emergency costs on a credit card (whether this be an existing card or a new card). You must pay this back in full the following month. If you do not you will be charged interest on the amount you still owe. Never pay the minimum amount – pay in full every time. If you cannot pay the full amount on this one off situation – pay this off as soon as possible!
- Personal Loan – The last resort is to take out a personal loan to cover the costs of the emergency. Again you will be charged interest on this loan and this will continue until the loan is paid back in full. This is a last resort.
Interest Calculator – only if you need it!
If you find yourself in a position where you need to use a credit card (and cannot pay the full amount in the following month) or personal loan – before you do anything work out the following:
- What is the APR (interest charged) on the amount borrowed?
- How many months will it take you to pay back the borrowed amount (remember this needs to be as soon as possible)?
You can use this calculator to work out what you would need to pay based upon the above. Make sure you are strict on your payment plan
Now go out and build that emergency fund!
Have your emergency fund in place and want to start investing?
Check out the Invest area of The Long Commute.
Need to free up some extra cash and gain a secure foundation to support your emergency fund?
Check out the Saving area of The Long Commute.
Need to increase your income and build another stream of income?
Check out the Hustle area of The Long Commute.