Where should I keep my Emergency Fund?By Money Mage · · Emergency Fund, Frugality
With interest rates on cash savings accounts now tending towards 0%, it’s becoming more difficult to decide where to keep your Emergency Fund.
There are competing concerns - keeping up with inflation, but also as close to instant access as possible.
An Emergency Fund is a critical tool in keeping your finances healthy. But if you don’t look after your Emergency Fund, inflation will erode it’s purchasing power. Over 10 years, this will hurt your finances.
Here are some thoughts on how to keep your Emergency Fund healthy.
What is the problem with Cash Savings?
Cash Savings that are not at an interest rate at least at inflation. Now, cash savings have their benefits. They reduce volatility. They’re often more readily accessible. But the biggest problem with cash savings is keeping up with inflation.
For us, having an Emergency Fund that’s just keeping up with inflation is all that’s important. The funds are not there for growth, they are there in case of an emergency. But, £10,000 kept at below inflation from 2008 would only be worth around £7,500 in 2018. That’s a 25% decrease in spending power.
That’s why it’s so important to keep up with inflation with your cash savings.
Why you care about liquidity for your Emergency Savings
But there are competing concerns with Emergency Funds. After all, they are intended for emergencies.
Car breakdowns, washing machine breakdowns, a broken window, job loss, temporary ill-health, vet bills. You name it. The unexpected happens, and Emergency Funds are a great way of preparing for the unexpected.
When emergencies happen, you often want access to your funds quickly. Like today, or tomorrow. You may be able to stretch a bit further, but you get the point. In an emergency, time matters.
Need to cover your insurance excess after a car accident? You don’t want to be waiting days or weeks for access to your cash.
So having your Emergency Fund tied up in illiquid assets is not ideal.
But should you keep all of your Emergency Fund in instant access cash when instant access cash savings are almost all tending towards 0%?
What can we do?
Option 1: Interest Bearing Current Accounts
Many current accounts in the UK offer relatively decent interest rates on small amounts of deposits - £1.5K to £5K. These are usually just above inflation.
These are ideal. We keep around 3 months of expenditure in instant access current accounts with the best interest rate we can find. We switch banks or change accounts now and then to keep up with the best rate on the market.
We’re a couple, so we each have one to act as our main current account where are income is paid into, then we also have a joint account. So we split this across 3 accounts.
Option 2: Bounce Sign Up Bonuses on Current Accounts
If you can’t find a current account yielding a decent interest rate, you might be able to find a current account offering a ‘switching bonus’. Often these are around £100-200. That’s quite a bit. Juggling a couple of these is enough to deal with inflationary pressure on £5,000-£10,000.
Switch to the account offering the bonus. Instead of spending that switching bonus, add it to your emergency fund stash as ‘interest’ for the year. Or invest it. Repeat this once a year with an account or two you move around, and you’ll easily beat inflation.
Option 3: Instant Access Savings
There are instant access savings accounts that have inflation-beating rates, even during the chaos of 2020. The best rates are often on accounts that you can only access a limited number of times, say twice or three times a year.
As these kinds of accounts are most popular with building societies, it may take 24hours to 48hours for money to hit your current account from a transfer. So keep that in mind. Or you’ll need to have a branch locally to nip into if they are open.
We keep around 6 months of expenditure in accounts like this.
Option 4: Regular Savings Accounts
Accounts that offer the best interest rates at the moment are regular saving accounts, but they are on limited cash deposits per month, ranging from £50 to £500, but they offer interest rates of up to 3%.
The problem with Regular Saving Accounts is they are a bit of a trick, whilst they have an interest rate of say 3%, you don’t build up enough funds in the account until maturity.
Say I have a 3% interest rate and can save £500/mo for 12 months. £6,000. You’d be forgiven for thinking you’d earn £180 interest (3% of £6,000).
But that isn’t the case, as you are drip-feeding the account £500/mo. You only earn only £98.4 interest, around half of what you might have thought. Simply because the account has less in it at the start.
So often you find yourself having to cycle through several Regular Saving Accounts which isn’t ideal from a time point of view.
We just have one regular saving account each, and drip feed the maximum contribution per month. This is the rest of our emergency fund and is around another 12 months expenditure.
Option 5: Notice Savings Accounts
Whilst falling out of fashion, we used to make significant use of notice savings accounts for our emergency fund.
These are savings accounts where you have to provide notice to withdrawal, say 90 days, or face an interest penalty.
Notice Saving Accounts tend to offer better interest rates than instant access savings accounts. They are suitable for ‘instant access’ emergency savings as long as you have some emergency savings in non-penalty accounts to use first. Then you either make use of the 90-day notice or take the interest penalty in a true emergency.
Option 5: Premium Bonds
Premium Bonds are a UK government-backed saving scheme. They act like a lottery, each £1 you save is a ‘ticket’ in a monthly draw of prizes. The prize pool is 1% per annum, and on average you’ll win about that. But there is also the chance of a bigger £1m prize every month.
Prizes are tax-free.
Again liquidity is not instant access and it will take a while to get funds withdrawn, so keep that in mind. A big attraction of Premium Bonds is they are backed by the UK treasury, so are about as safe as you can get.
Option 6: Cash ISA
Cash ISAs used to be a great way of keeping large portions of your emergency fund - especially if you rarely if ever dip into them. Nowadays however interest rates on Cash ISAs are some of the worst on the market, so you may struggle to find
The downside of keeping in a Cash ISA is if you withdraw, you’ll lose that part of your ISA allowance that tax year unless of course you contribute it back.
Liquidity is also not as good as a current account, but at a bank or building society like Nationwide you can probably access on the day.
Option 7: S&S ISA or General Investing Account
A braver approach is to invest your emergency fund in a S&S ISA or General Investing Account.
If you invest in fixed income assets like bonds, or a very small % of equities, this is an approach that you can use for a portion of their emergency fund. But it’s not for everyone and comes with risk to your capital.
Be aware of risk. Even globally diversified equity index funds, and globally diversified bond index funds may lose value, so your emergency fund may decrease in value, and often at times of market volatility. By investing your emergency fund, your capital is at risk. Which quite possibly defeats the very purpose of having an emergency fund!
Another key point is to watch out for charges. Ongoing fund charges and platform charges will eat into your gains. Your brokerage account may have charges for instant trades, for example, if you hold funds in an Exchange Traded Fund there may be a fee to trade immediately vs at the brokerages’ batch trading point in the day. There may also be wire charges for transfers.
Times of market volatility have a higher chance of intersecting with periods where you might need your emergency fund - i.e. due to redundancy or economic downturns.
Liquidity must also be considered with brokerage accounts. You first have to wait until your assets are sold, and potentially settled. This can take up to 3 days. After they have settled, you need to wait until the money is transferred to your UK current account, which may be as long as a week.
Given the liquidity and capital risk, this is certainly not for everyone. We hold all of our Emergency Fund in cash as this isn’t for us.
Option 8: Offset Mortgages
If your mortgage interest rate is above inflation, which it possibly is unless you are on a base-rate tracker, you may find an offset mortgage facility an option.
Keep your Emergency Fund in your offset mortgage’s cash savings, and only dip into it if you need.
That way, you’re saving mortgage interest - so not losing money due to inflation.
Option 9: Mortgage Overpayments with Borrow Back
Similarly to an offset mortgage but with much worse liquidity is mortgage overpayments. Some mortgage overpayments offer a borrow back function, so you could use part of your emergency fund to overpay your mortgage, and ‘borrow back’ if you run into an emergency that needs a bigger chunk of capital. Be aware of liquidity here, it may take a few weeks to arrange a borrow back.
Similarly, you can treat mortgage overpayments as an emergency reserve. Some mortgages provide the ability to use mortgage overpayments as a reserve which you can use for a payment holiday. It won’t help replace your broken washing machine, but it will help reduce your mortgage payments. If your mortgage does not offer a borrow back, this is highly illiquid as the funds can only be used for a mortgage payment holiday.
Option 10: Rolling Emergency Fund
A more aggressive approach is to split your emergency fund up into chunks that suit your probable emergency and liquidity needs.
For example, it might be worth only keeping 3 months of your emergency fund in instant access inflation-beating cash savings.
But you might figure that more serious emergencies like a job loss don’t need to be in instant access cash. Some kind of emergencies you have a bit of time to plan for, and if you keep 3 months of expense in instant access cash you can use that first to buy more time.
You might break down your emergency fund like:
- 3 months expenses in instant access cash savings - instant liquidity
- 3-6 months expenses in notice / penalty cash savings account - 24-48hr liquidity
- 6+ months expenses in low risk investments (i.e. low % equity, high % bond), tax efficiently wrapped in an ISA - 48hr+ liquidity.
Like a rolling wave, you first use #1, and if that’s not enough you use #2, and if that’s not enough you use #3. #1 gives you a 3-month runway immediately - probably enough to find another job, or fix a car, or pay for some repairs on your house. And 3 months is more than enough to withdraw any funds from less liquid investments. Well, maybe not P2P, but P2P lending is super risky and is suffering a liquidity nightmare, so should be avoided for emergency funds.
Always top each wave back up to their high watermark if you do dip into them.
This way, you stand the best chance of beating inflation with your emergency fund.
How do you keep your Emergency Fund beating inflation? Let me know in the comments below.
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Sources and Attribution
- Car Crash (c) sylvar, CC-BY