No matter where you are right now with your financial goals, there is an ever-present need to have reasonably liquid cash to hand to cover life’s emergencies. There are varying different views on how much should be in one (6 different sites, 6 different theories) but they are all agreed on one point: You must have an Emergency Fund.
What is an Emergency Fund
In its simplest form, an Emergency Fund is a cake tin under the bed you stash money in for those unexpected (and/or unwelcome) events in life. An important distinction between a general ‘slush fund’ or overdraft is your emergency fund will cover you for The Big Things. Maybe you get made redundant; maybe you are struck down with an illness for 9 months but your sickness cover from work only covers you for 6 months at full pay; maybe you must have a vehicle for your work, and yours blows up.
There are thousands of different events some of us would consider a personal emergency that others would not. My car recently gave up the ghost but it was not an emergency for me. I live in a metropolitan city with a superb public transport network. I live and work in the same city. If I lived in Cornwall 19 miles from my nearest railway station and worked and commuted every day to Devon however, it would be an emergency.
Why You Need An Emergency Fund
It’s a backup plan. It’s insurance you pay a premium to yourself for. It’s a cushion against the inevitable times in life that you’re in the middle of Yin and life decides you should have Yang’ed instead. It’s above all else, security for you and your family to know that if something goes wrong, you’ve probably either totally got it covered, or are a good way to having it covered.
Why Not Just Use Credit Cards
Some advocate using available lines of credit as your emergency fund instead, be that credit cards, HELOC’s, or some other credit instrument. This is a Very Bad Idea, in certain circumstances. I understand the thinking behind it, of course. Not every emergency is going to be one that involves your inability to continue earning an income, or continue earning an income at the same level as before whatever your emergency may be.
By definition an emergency is serious, unexpected and perhaps even dangerous. You cannot predict or rely on the fact when an emergency strikes you or your family (it is when, not if) that it will be of a sort you can use credit for instead of liquid cash.
What if you lose your job? Get fired? Get made redundant? <insert any other kind of financially cataclysmic event here>? Then what? You are left with no immediately available cash to work with beyond what is in your current account from your last wage packet (if anything). You begin using your credit cards to live on, but your job search takes 4 months to find something that pays well and is something you enjoy.
Consider this: Could you continue to make the necessary payments on those cards, as well as your rent/mortgage, utilities, council tax and every other payment that comes out of your account each month? Even if you do manage to make the minimum payments and put everything on your cards, what’s the pay-off plan? Your outgoings are £950 a month, your new job pays £1,000 and you’ve just popped £3,800 on your credit card over the past 4 months.
Bad news. Your minimum payment is £76, and you don’t have £76 spare. Even if you do free up the extra needed, the bad news won’t end there. Paying that minimum would take you over 35 years to pay back £3,800 (at a representative 15%) and cost you £5,800 in interest alone.
Where to Keep Your Emergency Fund
You can avoid all the bad points above, by making your own Emergency Fund. During the example emergency above we needed £3,800. By planning ahead and saving that amount in a high interest, easy access savings account we didn’t even really notice our emergency.
Why? Because planning for it made it an annoyance to our life, and not a catastrophic event. We transferred what we needed each month to our current account, and life carried on. A new job arose, and off we went. That spare £50 went back into slowly rebuilding our fund back up for whenever it may next be needed.
Having an Emergency Fund turned a 4 month jobless period into a mere annoyance and not into 35 years of credit card servitude and bad credit history from potentially failing to meet minimum payments.
How Much To Keep in Your Emergency Fund
As I pointed out at the beginning of this post, everyone who has ever written about Emergency Funds has a (differing) opinion on how much is enough. Some say you should save 6 months salary. Some up that to a year. Yet others reckon at least a month’s living expenses should be kept by, just in case.
In the current economic climate I advocate that everyone should keep 6 months of living expenses by in your Emergency Fund. Not only do I advocate it, that’s precisely what I have done.
Why living expenses versus actual pay? You may get paid £5,000 a month, but if your fixed outgoings are only £1,500, why scrimp and save the extra when it won’t necessarily provide you a tangible benefit. Your emergency fund should cover your fixed, important costs whilst – for example – out of work. It is not designed to cover lifestyle wants such as your daily visit to Starbucks.
How To Start An Emergency Fund
If you’ve never really thought about saving before, or if you have savings but dip in and out as needed, or have no savings whatsoever, the thought of starting and saving up 6 months of living expenses that you may never need can seem ridiculous, unnecessary, and a waste of your ability to live life. I’ve heard lots of arguments against starting an emergency fund. Most people’s opinions change when they experience that emergency in life where an emergency fund would have turned an emergency into an annoyance.
By then, it is just simply too late and they’ve already landed themselves in 35 years of credit card debt as a result.
Start Small, But Do Start
Unless you do have a great amount of disposable income, you’re not going to have lots of cash to throw into a savings account right away. So start with a small amount of say, 2.5% of your take-home pay. That’s £25 if you take-home £1,000. It might seem a pointless amount but even ignoring compound interest that’s £300 in the first year of trying if you do nothing else.
If you try and save more than is comfortable, you won’t keep it up. Start with my 2.5% above and see how you get on. Do it the moment you get paid, and learn to live without it. After a few months you won’t even notice it any more.
Set it up to happen automatically by standing order. If you set and forget, it will keep on going. If you have to do it each month, you’ll find reason after reason just not to do it.
Increase as able
The Telegraph newspaper website has a section dedicated to money saving tips as well as the Frugal Friday series on this very website and countless others. After reading around you manage to free up another £50 a month that you didn’t have before and don’t necessarily need. Why not increase your £25 standing order to £70 and leave £5 as a treat to yourself each month. Assuming it took you a month to make all the necessary changes after the first 12 months you now have £795 in your Emergency Fund and that may already be one month’s living expenses for you.
If you live with a partner, pool your finances and make a concerted effort to build it up together as quickly as you can.
If you are commission based or get a bonus from work then consider using that as a massive jump-start to your Emergency Fund. Particularly unexpected bonuses, as you didn’t count on getting it, so you won’t notice if it isn’t spent.
Only touch it in emergencies
It might seem obvious, but only touch your emergency fund in emergencies!
It can be nice to feel you have cash for a rainy day, but it will only be useful to you if you are honest with yourself and only touch it when you have a real emergency on your hands. An emergency is not defined (despite how some people act!) as needing The New iPad, or a similar want.
Photo credit 401kcalculator.org
Tags: Emergency, Emergency Fund, illness, sickness
Category Financial Guides, Money Management, Savings
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