The Emergency Fund – how much, how to start and where to keep it

What is an emergency fund and how important is it?

Whilst I’ve had savings in the past, I’ve never ring-fenced a set amount that is only to be used for emergencies. Emergency funds are different from general savings in that they are a pot of money, set aside in an often separate account and are sacred, only to be used for emergencies that cannot be budgeted for.

When I started out improving my financial fitness, I was reading all the books and listening to the podcasts and was soon well informed about the need to have a stash to fall back on when things got dicey. ‘Miss Elanous’ could parade herself unannounced through the door any minute.

So when my washing machine, tumble dryer and oven all packed up in the same month, boy was I glad that I’d got my backside into gear and saved an initial £1,000 emergency fund. Now I was ready. Bring it.

Everything blew up!

I’d like to think it was part of an elaborate conspiracy that our washing machine, tumble dryer and oven all packed up at the same time. More likely of course, it was just bad timing. I had Travis’ ‘Why does it always rain on me?‘ playing in my head in the background (for those young or sober enough to remember the 90s).

What I learnt, thankfully not the hard way, is that having an emergency fund is absolutely critical to financial health. It stops you going in to debt, it develops a healthy money mindset and it allows you to handle unplanned emergencies with confidence. I now see why Dave Ramsey calls this ‘Baby Step One’.

When setting out, I’d had 3 burning questions along the way on how best to go about setting up an emergency fund:

  1. How much should I save?
  2. How should I save for it?
  3. Where should I keep it?
How big should your emergency fund be?
Is bigger always better?

How big should your emergency fund be?

OK, so I’ll ask the question; how big is yours? And does size really matter? Ultimately, it’s down to the individual.

I knew from all the material out there, that there is a lot of debate about how big an emergency fund should be.

In Dave Ramsey’s Total Money Makeover book, he outlines his seven ‘Baby Steps’ approach. He is emphatic that even when facing crushing debt, the absolute priority is to set up a small emergency fund, hence ‘Baby Step One’. The figure he puts on this is $1,000 (or £1,000). It can be quite an achievable amount, whether you divert some savings, reduce costs elsewhere or hit up Gum Tree or Craig’s List and sell some of that crap you never use.

£1,000 is, to a degree, an initial arbitrary amount. It will cover many things that break and if something that can go wrong costs more than this to fix, then insurance is worth considering.

But this only covers material things. How about if you lose your job? What if you develop an illness that isn’t covered by insurance? Or perhaps you think rolling down a hill after waaaaay to many sherberts one Saturday night is a good idea, break your arm and now can’t work for 12 weeks? (Eh hum….not me ‘gov, honest).

£1,000 doesn’t even scratch the surface of these situations and I see far too many people save the £1,000 initial emergency fund and stop there, thinking ‘job done’. Baby Step Two is about paying off debts and many people forget that Step Three involves refocussing on that emergency fund and significantly increasing it. Makes more sense, but where do you stop?

It depends on your individual circumstances.

If you are single and living a frugal lifestyle or perhaps are a family with multiple incomes, it could arguably be a minimal amount and you could invest the rest to leverage your position.

Personally, we are not in such circumstances. As a young family with two children and one income, we need more protection behind us.

Originally my emergency fund was £1,000. However after the Hotpoint armageddon last month, it is down to a paltry £200. My plan, then, is to rebuild that emergency fund (back to Baby Step One) and shoot for at least one month’s basic expenditure. By basic, I mean the critical bills we’d need to pay for, our financial obligations and the food we’d need to buy. We would accept the fact that we would be tightening out belts for that period and any luxuries or disposable income would be forfeited. So for us, that means about £2,500 for the month.

As time goes on and we reach Baby Step Three, I will likely increase this to three month’s worth, so £7,500. I feel that gives my family of four a solid footing on which to rely should our single income stream dry up. I may review this over time of course.

In the same way you would customise your fitness activities around your health goals, subject to your current condition, body composition and other commitments like time, so should your financial fitness plan be customised to your personal circumstances in the same way. How big your emergency fund is should be based on your set-up, your tolerance to risk and how it makes you feel. You do you. Just make sure you at least have one.

Three tactics to kick start your emergency fund
Three tactics to kick start your emergency fund

How do I save for an emergency fund?

We’ve now established that you absolutely must have an emergency fund and have given yourself an initial target. Now, how to get there?

It can seem daunting if you’re already living pay check to pay check and there is always a lot of month left at the end of the money. I know exactly how that feels. The good news is that with focus and intentionality, there are three key actions you can take to kick start some surplus income and get that emergency fund going.

Three tactics to kick start your emergency fund:

  1. Reduce your outgoings
  2. Sell stuff
  3. Divert debt over-payments

1) Reduce your monthly costs

There are lots of areas you can look at here. Job one is to properly budget so you know what money is going where, then look at where you can make savings. This can range form unnecessary subscriptions to renegotiating with utility suppliers. For more ideas on where to cut monthly costs, check out Principle One – Reducing Costs of the Beginners Guide to Financial Independence. By following these steps, I reduced my outgoings by over £100 a month. That’s a £1,000 emergency fund done in 10 months! I also now keep a spreadsheet of what contracts renew when, so I’m sure to review the market, know what offers are on and renegotiate with my suppliers.

2) Sell stuff you no longer need

Selling crap that you no longer use not only brings in some precious money to kick start that emergency fund, but it’s also incredibly satisfying. There is a real sense of emotional freedom by decluttering yourself and your house of material objects that no longer bring any value to your life. We realised we had a tonne of baby clothes and toys in the loft gradually gathering dust. We cleaned it all down, bagged it up and hit out nearest Little Pickles (baby markets all over the UK). Given the snow was the worst the UK had seen in a decade, we still made almost £150 in 2 hours with very little gear left over. What was left got donated to a local charity.

3) Divert debt over-payments

When I initially saved an emergency fund of £1,000, I had to mentally wrestle with the fact that this emergency money could be £1,000 more cleared from my outstanding credit and a significant step forward to being debt free. When I looked at it logically though, it made sense. At some point in time, something unexpected is going to happen, right? It’s inevitable. Without the emergency fund, when the shit hits the fan, where’s the money going to come from? That’s right – credit (if you have it available, of course). And now that hypothetical £1,000 emergency is attracting interest. Maybe 20% on a credit card (or higher if using a pay day loan, shudder). Think of that situation now costing £1,200 plus. That will only get worse the longer you take to pay it off. And if you couldn’t save a small emergency fund in the first place, then how are you to pay this off? Minimum payments take a whole lotta time and cost a whole lotta money. Now I’m rebuilding my emergency fund, I’ve diverted an £100 monthly debt over-payment to hit my new target ASAP.

To really maximise your emergency fund gains, look at all three of these tactics and in a surprisingly short time you can have that comfort from being ready for the unexpected. Just make it your number one focus and priority an commit to it.

Accessibility vs. performance
Accessibility vs. Performance

Where do I keep my emergency fund?

So you have a target and you have a plan. Nice. But where should it be kept? This is a hotly debated topic and will come down to how your circumstances support and how you feel about:

accessibility vs. performance

The very basic premise of an emergency fund is that it’s a pot of money that can be used for emergencies. The nature of emergencies is that they bite. They bite hard and they bite fast. They can be upon you before you know it. It makes sense, therefore, that you can access your emergency fund as quickly as possible to put out the flames pronto. If something big is broken, it’s usually important to you, and being without it will likely have some form of negative impact. If you’ve lost your job at zero notice, how do you pay important bills and put food on the table?

Instant access / low performance

Accessibility is an important aspect for most people and you don’t want that money locked away. Most therefore consider a ‘high interest’ (cough….splutter….if such thing exists these days) savings accounts or cash ISA. Many are instant access but as you can guess, with current interest rates as they are, gains will be minimal and won’t even keep up with inflation. So that £1,000 today won’t buy you £1,000 of the same stuff in 5 years time. You’re going to have to keep topping it up. Also, if you withdraw from an ISA, and have used you full allowance, you cannot put that money back in during the same financial year.

Delayed access / high performance

On the flip side then, your emergency fund could be kept in something more high performing, such as your Stocks and Shares ISA investments wrapper. Making an average return of 8% over the long term, this will likely out-perform current inflation. But getting at it is trickier and takes time. What do you do in the meantime?

Using credit

One other way of looking at this, is do you really need your emergency fund as real money? Big Ern writes a compelling case for this in his infamous blog. Why not have a £10k limit on a credit card? Well, it depends on a few things:

  1. Do you actually have the money? Do you actually have the £10k somewhere else, such as investments, that can be accessed to pay off the full credit card balance? If so, then the credit card can be a valid temporary way of accessing money whilst you draw down your emergency fund that is tied up in a high performing account.
  2. Do you have the discipline? Do you have the control to pay that credit balance off in full ASAP? Can you resist the temptation not to splurge on that easy, open line of credit and ‘pay it off tomorrow’? If you’ve had an unhealthy relationship with money or are in recovery, then watch out for this.

As always, this is a personal choice. For me, whilst my emergency fund is fairly low, I have debt and I don’t have huge savings, then I’m not comfortable with using a line of (more) credit. This only really works for those well on the way to financial freedom. Personally, I get a psychological boost from having that cash there ready and waiting and that’s exactly what I needed recently.

Initially, my emergency fund was £0, so where it ‘was’ didn’t matter two hoots. Now, whilst I’m building it up to my new target of £2,500, I have put my emergency fund in a separate savings account. A meagre 1% interest, but it is physically and mentally ring fenced and that makes my feel good. As my financial fitness improves, once the debt has gone and my investments increase, I may consider moving to a credit-line style model.

Using the emergency fund feels so good
Before you ask; this is not me – it’s random stock photo guy looking like how I felt

Using the emergency fund – it feels soooo good

Having only recently ring-fenced that £1,000 initial emergency fund, it was only 3 months before I had to use it.

Yeah it hurt. It hurt good. My emergency of replacing and repairing my washing machine, tumble dryer and oven cost £800 and I watched, with a metaphoric wobble in my chin, as my fund nose-dived to £200.

But it also felt good. I mean, really good. For the first time in my life I had planned for the worse, the worst (OK not game changing but it still counted) had happened and I was ready. Sure, it may have set me back in some way, but my journey to being debt free remains unwavering and continues its relentless pursuit to Financial Independence.

Here’s to the pursuit of financial fitness and freedom.

FIguy101

This blog has been part of the Building Wealth series, which includes articles on savings, investment and long term wealth accumulation. If you liked the article please share, comment and follow us for more. We generally hang out on Twitter and Instagram. Alternatively, leave your e-mail address to get notified when we release new content. See you next time.

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