Setting up an emergency fund is one of those tasks many of us promise ourselves we’ll get around to ‘later’ or ‘soon’ or when we get our next pay rise. But it’s something you can do in minutes, and it can be a huge load off your mind to know if anything goes wrong, you’ll still be able to cover your bills.
What is an emergency fund?
You might choose to keep an ‘emergency fund’ of sorts for life’s unexpected expenses – car breakdown, boiler breakdown, fines, etc.
For our US readers, you might want to check out commoncentslifestyle's article on how to build an emergency fund.
But in the world of personal finance, an emergency fund generally refers to a savings account that provides a financial buffer in the event of a disruption to your regular income. Some people might use their emergency fund to facilitate a career change or take a much needed break away from work, but the real idea is to protect you against the big, unplanned things like getting fired, redundancy, or injury.
This is something everyone should start to build up while they are in paid employment, ideally as early as possible, but there are two groups of people for whom having an emergency fund is particularly important – the self-employed, and regular investors and traders. If you fall into the former, you’ll need an emergency fund to act as ‘sick pay’ should you become unable to work for any reason. For the latter, it’s crucial to have an emergency fund in place to keep you afloat in the event of big losses.
Why is an emergency fund important?
Emergency funds are important for several reasons.
- While employment and income can stop, bills, rent, and mortgages still have to be paid.
- Periods of unemployment or other situations of income loss can be indeterminate. The past year alone has been an abrupt reminder of how quickly things can change, and how slowly they can sometimes recover. Simply “getting a new job” is not always possible straight away. Even when you find suitable positions to apply for, interview, application, and vetting processes can take weeks.
- Thirdly, although we are fortunate to live in a country that provides aid and benefits to those who need it, they’re often not enough to live on continually. Many benefit schemes like Universal Credit are designed to pay the bare minimum to cover rent, leaving no spare money for food, clothing, or transport. Having an emergency fund gives you something else to rely on in difficult times.
- Finally, and crucially, emergency savings can save you money by preventing the need to take out loans or credit cards. For the 15% of Brits that have no savings at all, the only means to pay for an unexpected expense is through borrowing, often with interest on top.
How big should my emergency fund be?
There’s not really an upper limit on an emergency fund – the more you have stashed away for a rainy day, the better. But generally speaking, your emergency fund should correlate to your lifestyle and income.
The rule of thumb for an emergency fund is 3 months’ income. This is because 3 months is a reasonable amount of time to find a new job, spanning the time needed to update your CV, start searching, applying, interviewing, and then waiting for the position to start.
Although the healthier the emergency fund the better, 3 months’ salary is a realistic goal. Let’s say you earn a salary of £30,000. This means you’d take home £24,000 per year, or £2,000 per month. On this salary, a 3-month emergency fund would amount to £6,000. If you put away £250 per month, it’d only take you 2 years to achieve this savings buffer for any worst case scenarios. If you could stretch to saving £350 per month, it’d only take a year and five months. Doesn’t sound too bad, does it?
Where should I keep my emergency savings?
The point of an emergency fund is that it’s readily accessible in case of, well, an emergency, so you’ll need an instant access account. Interest rates can be lower with these than with closed savings, so shop around, and consider online accounts over high street bank accounts, which tend to pay higher rates due to their lower overheads.
If you’re feeling like this is a daunting task to begin, naturally, there’s tech to help. Apps like Plum (which you can read more about here) and MoneyBox automate the process for you, enabling you to automatically save regular amounts on pay day, or round up purchases to add your change to savings funds.