What is an Emergency Fund?By Money Mage · · Emergency Fund, What Is, Frugality
Most households can’t save. An FCA survey in 2018 states 41% households would struggle with an unexpected bill of £100. 10% of households are ‘in difficulty’. Having missed credit commitments or domestic bills in the last 3 months
Fiscal policy is encouraging households to spend not save. Spare household income is so low, people are on the precipice of a debt spiral.
The good old-fashioned rainy day fund comes to the rescue.
If you had a rainy day fund of half of your monthly income, a one-off £100 bill would not be a problem. If you have a rainy day fund of 6 months of net monthly income you free yourself from the system. There is no spoon.
An Emergency Fund:
- Is not used for day to day purchases like food, or bills, or rent, or mortgage payments. Unless in an emergency!
- It is not used for planned purchases, like holidays, or a new car, or a deposit for a new house.
- Doesn’t have to be big. Start small. An Emergency Fund of £100 might make the difference between a not-so-great month and a terrible month.
The Emergency Fund is your “rainy day fund”. It’s a stash of cash that you can access quickly to pay off an unexpected expense.
An Emergency Fund is your lifeline. Your first step on the path to freedom.
Why you need an Emergency Fund
There are many reasons why you might need an Emergency Fund. The biggest reason is peace of mind and freedom:
Incase you lose your job or income
Do you worry about losing your job? What would happen to your household expenses if you had no income for 3, 6 or 12 months?
Are you self employed or run a small business? Are you worried about how you’d pay the bills if business dries up?
Imagine having 12 month of expenses put aside.
What a weight off your shoulders that’d be. That’s what an Emergency Fund can do for you.
To pay for an unexpected expense
Remember half of UK households would struggle to meet an unexpected bill of £100.
There are unexpected expenses everywhere: Your washing machine breaks down. Your fridge breaks down. The dog breaks a leg. You have a car accident. You become ill and have to take some time off work. You put your mobile phone in the washing machine by accident. A tile falls off your roof. Your insurance premium goes up unexpectedly. Your rent goes up unexpectedly.
There are 101 reasons why you might have an unexpected expense.
An Emergency Fund can cushion this unexpected expense without impacting your monthly finances.
To build good financial habits
Learning to save an emergency fund of 1 months expenses is a great way to learn how to start saving. Financial Independence is all about habit building.
We all need to learn how to save, before we can learn how to invest. To climb a mountain we have take the first step.
By growing your Emergency Fund from 1 week to 3 months of expenses, you’ll learn how to treat money with respect.
To unlock your freedom
With a larger Emergency Fund, say 6 to 12 months of living expenses you become free.
Imagine something changes in your life:
- You get a new boss who’s a ringpiece.
- Your health takes a dive.
- A family member becomes ill.
- You lose your job.
If we are feeling insecure about where we’ll sleep, how we’ll eat, how we’ll pay the bills, we won’t be thinking rationally about these changes in your life. The Emergency Fund kicks away worries about security.
The Emergency Fund gives you peace of mind. You can make the right decision for you. It allows you to look at the situation with more objectivity.
How big should my Emergency Fund be?
This will depend upon your personal situation:
- How much do you have saved / invested already?
- How stable is your job or your income?
- How easy is it to get another job, or get another stream of income?
If you answered ‘none’, ‘not very’ and ‘quite hard’ to the three questions above - you should look to have a larger Emergency Fund.
Emergency Funds are usually measured in net monthly expenses. So if every month I spend £1.5K, a 3 month Emergency Fund would be £4.5K saved.
The Money Mage household has an Emergency Fund equal to 9 to 12 months of household expenses. This is on the large side, and arguably should be invested not saved.
No amount is too small. Just start saving. £1 a day will net you nearly £400 in 1 years time in a 5% savings account.
Where to put my Emergency Fund?
Initially start with your Emergency Fund in instant access Cash Savings.
Try ‘introductory bonus’ Current Accounts. They often have high Interest Rates between 3% and 5%. Nationwide and TSB both have offers at the moment. Usually payable on small deposits up - about £2.5K
These are plenty good enough to get you started saving.
As your Emergency Fund grows, look for best rate instant access cash savings. You can find rates around 1.5% at the moment.
Some argue that an Emergency Fund is just ‘piling up cash’. Some say you should just invest it. This is a valid argument for those later down the path to Financial Independence.
If you have tens or hundreds of thousands of pounds invested, you already have a big buffer, Why not just roll up your Emergency Fund into your other liquid investments?
If you are just starting out on your journey, start saving in Cash accounts. Then learn and practice The Principles of Financial Independence.
How to build my Emergency Fund?
The Principles of Financial Independence will help you build your Emergency Fund.
The 8 Principles in full are:
- #1 - Develop a healthy scepticism for debt.
- #2 - Relentlessly grow your income.
- #3 - Measurements over limits.
- #4 - Compound, compound, compound.
- #5 - Frugality over lifestyle creep.
- #6 - Work on your habits, good & bad.
- #7 - Look after yourself before your wealth.
- #8 - Continuously improve.
In simple terms, to build an emergency fund you need to save.
In order to build an Emergency Fund quickly:
- Look to maximise your earning potential. Can you get a higher paid job? Can you work another job in the evenings or weekends? Can you earn some side income?
- Look to minimise your expenditure. Reduce your expenditure on clothes. Food. Bills. Phones. Cars. Holidays. Takeouts. Restaurants.
- Clear your High Interest Debts. Start with the Highest Interest.
- Increase your Savings Rate. Put as much a month into a Cash Savings Account as you possibly can.
Some say building an emergency fund is a waste of time. “You should just invest!”
If you are already well on the way to Financial Independence, sure reduce your cash emergency fund and invest more.
If you are just starting out, you need to learn to save before you can learn to invest
What do you think?
Subscribe now, follow me on Twitter @moneymagery, stick by your principles and you’ll be mortgage-free in no time.
Sources and Attribution
- Car Crash (c) sylvar, CC-BY
- 20 pound note roll (c) Images Money, CC-BY