How to balance financial security through an emergency fund

Balance financial security with an emergency fund

Could your finances survive a shock event? That’s a question you should be asking yourself. One way to reduce the pain is through an emergency fund. This article asks what they are, and covers setting one up and managing it. 

What is an emergency fund?

An emergency fund is a pot of money that you use when something unexpected happens that could hurt you financially. 

It could be employment issues, such as if you lose your job. Perhaps you have an accident or illness that temporarily makes it hard to work. Or it could be for unexpected expenses, like home repairs or legal costs.

It’s different from normal personal savings, such as those for a holiday or a property deposit. Those savings are meant to be spent once they reach their savings goals, whereas an emergency fund should remain untouched until it’s needed.

The point of emergency savings is that they cover unavoidable payments. Whatever happens, you will have to pay them quickly, so it’s not something you can put off. 

Essentially, you have three options when such expenses emerge:

  • Take out a bank loan

  • Borrow from friends or family

  • Dip into your savings.

The alternatives can be severe. If you have a mortgage, for example, you might lose your home, which is the collateral on the agreement. These are circumstances where you don’t have time to save up, work extra hours or sell things, where essentially you need the cash yesterday. 

If the worst happens, don’t forget to contact lenders, landlords, utility companies and other debtees quickly. They might be able to help by temporarily reducing or pausing your payments.

How much emergency fund should I have?

Everyone’s needs are different. Most experts, such as HSBC and Lloyds, agree that three months’ essential spending should be the minimum in an emergency fund. 

For example, if your monthly essential spending is £1,500, you should save a minimum of £4,500.

What we mean by “essential spending” is your mortgage or rent, bills, Council Tax, fuel costs, and so on. Non-essential expenses such as entertainment subscriptions, eating out, and other treats should not be included. 

Three months should be enough time to stave off the immediate emergency, and put plans in place to raise extra cash if needed. If you can get to six months’ worth, you will insulate yourself even more.

The fund is a safety net to get you through tough times. If you feel confident that you would be able to rely on friends or family, and saving would hurt you financially right now, you could scale down the figure somewhat.

Setting up the fund

A safe way to save is to set up a bank or savings account specifically to build an emergency fund. 

Working out how much to contribute each month is the tricky part. You want to get there as soon as possible, as you never know when disaster will strike. You also don’t want to cause yourself hardship in the meantime. 

Take your essential monthly spending and subtract it from your monthly take-home pay. What you’re left with is your disposable income. 

How much of that can you (and your partner) commit to putting in the emergency fund? Only you know what you can sacrifice. However, the more you spare now, the quicker you’ll reach your goal. 

When deciding how much to pay, a good rule of thumb is to follow the 50 30 20 rule. Considering your income, you should spend half (50%) on needs (essentials), 30% on wants (luxuries) and 20% on savings or paying off debt. 

Sometimes, sticking to such rules makes it easier to be a disciplined saver. 

Types of savings account

A regular savings account is the default account type for setting up an emergency fund in the UK. That’s because accessing your money is easy. You simply make a withdrawal when unexpected costs arise. 

In the meantime, you’ll be earning a moderate amount of interest. Other types of savings accounts offer different features, however.

A second type of account is a locked savings account. They are often fixed rate bonds, and offer higher interest rates than standard savings accounts. However, they are not suitable for an emergency fund as you won’t be able to withdraw the cash until the fixed term expires. 

That would defeat the object of the rainy day fund, as you need the cash fast. Also, you generally need to pay the whole lump sum into the account in one go. You might not be able to build it up gradually.

Paying into a cash ISA is a similar option. It’s tax-free as long as you only make the allowed contributions within a tax year. Again, it’s more of a long-term solution and isn’t necessarily appropriate for a rainy-day fund.

There’s a halfway house that might be worth considering, however. It is called a limited access saver account. 

As the name suggests, it limits the number of times you can make withdrawals over a given period of time. That could be, say, no more than five withdrawals in a year. 

Because of this restriction, you could earn higher interest than with an instant access savings account. Since you hopefully won’t be withdrawing your money regularly, you should never breach the withdrawal limits.

There’s nothing to stop you from opening a regular current account for this purpose, but you might be tempted to use it like a regular account. The interest rates will also be much lower, if interest is paid at all.

Setting your rules

Defining what an emergency is may not be as obvious as it sounds. For example, a small dent in your car is hardly an emergency that needs fixing immediately. However, a leaking roof is a different thing altogether. 

A leak can cause a growing repair bill as water damages other parts of your home, and it can affect your health. 

Try to make a few ground rules for yourself, so you’ll know you’re covered when you face a real emergency.

After you use the fund

If something crops up that causes you to dip into your fund, aim to get it back to 3 times your monthly essential payments as soon as possible. You’ve proved the fund’s usefulness now, so you shouldn’t need much motivation.

Money you never want to spend

An emergency fund is a great way of saving money because it instills discipline and serves a useful purpose. It’s all your own money and always will be, so if you ever decide you don’t need it, it’s there for the taking. 

It is good to keep the fund completely ring-fenced, though. Once the fund is full, you can continue saving for other things. After all, it’s much cheaper than loans and credit cards.

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