What is an emergency fund (and how much do I need)?
An emergency fund is the buffer between you and life’s surprises.
Life is a series of peaks and troughs. One minute everything is fine and you’re planning your next holiday, car purchase or what to plant out in your garden and the next, everything turns on its head and all your plans go out of the window.
Read on to find out what an emergency fund is and how you can make sure you are protected.
It could be something as frustrating as your washing machine refusing to drain the water, getting a flat tyre or a boiler breakdown. it could even be as serious as an economic collapse or a global pandemic that puts your job at risk. Right now, anybody’s world could be turned upside down.
In times like these, without any kind of funds set aside, you might be reaching for the credit card, taking out a personal loan or even selling the house as your circumstances change.
Ask yourself this question:
If you lost your income today, how long could you survive without taking on debt or dipping into your retirement fund?
Quite simply an emergency fund is your buffer between you and the myriad surprises that life throws at you; often at the same time. So, where to start?
The Rainy Day Fund: Your umbrella for the small stuff.
Many people live payday to payday and perhaps even start each month with a bank balance below £0, in their overdraft and it goes downhill from there. This really is life on the edge. There’s no margin for error and the cost of that boiler breakdown would definitely be going on the credit card.
Imagine how much less stressful it would be if you had a rainy day fund of £1,000 set aside for just this type of thing? It turns these frustrating events into a mere administrative task to sort out. Finding the money to solve the problem is one less thing to worry about.
How much do you need? Well, you are going to need £1,000, plus the amount required to clear your overdraft on the last day before payday.
Ok in theory, but if you’re already living in your overdraft, where exactly are you supposed to find that much money?
Good question.
You could go around your house and find things to sell online (CDs, computer games, old furniture etc.), you could cancel that satellite TV subscription (this alone is hundreds of pounds each year), eat out less or you could take a cheaper stay-cation this year rather than fly halfway around the world (although at the time of writing during Covid-19, you don’t have much choice).
Lots of little changes to lifestyle really add up over time, so before you know it, you’ll have the money.
WARNING! Don’t spend it! I know it’s tempting, you’ve put all the effort in so now you’ve got to reap the rewards of peace of mind. So where does it go?
A £1,000 Account Balance Is The New £0.
Remember that bit about starting each month at or below £0 in your current account? Here’s the trick. On the day before payday use your £1,000, plus the amount that’s required to pay off your overdraft so your current account balance is exactly £1,000.
This is your new zero, the starting place each month.
With easy round numbers, it’s simple to know when you are spent out each month and you have a £1,000 buffer for that new tyre or washing machine repair.
With this mind-set, you’ve done several things:
Paid off your overdraft.
Reduced your reliance on credit cards.
Cut out some unnecessary spending.
Provided yourself with peace of mind.
Feels good. However, it does come with a warning. Depending on how good you are at budgeting and self-control, it might be more sensible to put this £1,000 into a separate savings account so you can access it when you need to, but aren’t tempted to spend it.
The Full Emergency Fund: 3 to 6 months of your take-home pay that’s locked away.
Right, so now you have the rainy-day fund sorted out, what about protection against the flood? These are life-changing events like losing your job, sickness or a major probelm with your car or house. This fund needs to be separate from your main accounts and only used in case of emergencies.
Here’s a tip:
A new sofa or a family holiday are not emergencies.
This money needs to be kept under lock and key but accessible within a short period of time. This could be in a savings account with your bank, held in Premium Bonds or even a cash ISA. What you definitely don’t want is for your emergency fund to be tied up in the stock market or fixed term, illiquid investments. When you need the money, you need it fast.
Yes you are going to miss out on capital growth and a return on the capital you set aside, however you do gain a financial safety net and a barrier against a flood of problems.
Remember:
This fund is there for your protection, not to make you money.
But how much do you need? To work it out, look at your take-home pay, after tax and multiply it by three or six. If your spouse or partner is in full time work, three times your take-home pay is probably OK.
If you alone have to support a household of five people, then six times your take-home pay is going to be a better bet.
But what does that look like?
| Salary | Monthly | 3 Months | 6 Months |
|---|---|---|---|
| £20,000 | £1,400 | £4,200 | £8,400 |
| £30,000 | £2,000 | £6,000 | £12,000 |
| £50,000 | £3,100 | £9,300 | £18,600 |
| £80,000 | £4,500 | £13,500 | £27,000 |
| £100,000 | £5,500 | £16,500 | £33,000 |
| £150,000 | £7,500 | £22,500 | £45,000 |
| £200,000 | £9,700 | £29,100 | £58,200 |
So there you have it. Your own insurance policy and protection for the worst that life can throw at you. Yes it may take a while to save up and it will probably require some changes in your lifestyle to get there. However, don’t give up.
Use that bonus payment, save your birthday money, sell the things you don’t need or get another part-time job to raise the capital.
Build your emergency fund when the sun shines and it will look after you when it starts to rain.
To read more about personal finance and your money, you can find more articles over on our news page. Alternatively, if you have specific questions about building an emergency fund or anything else to do with your money, please get in touch to speak to one of our Advisers. Don’t forget, this article offers information about financial planning and should not be taken as personal advice.
Have you saved for an emergency fund? What are your top tips for raising the extra money needed? Share with us in the comments below.