Creating a budget
Taking the time to better manage your money can really pay off. From setting realistic goals to choosing a budgeting plan, learn more in this guide.
We’ve all experienced the stress of an unexpected financial emergency – a broken boiler, an expensive car repair or a damaged mobile phone. Setting up an emergency fund can help to cover these unplanned costs and make a difficult time that little bit easier.
What is an emergency fund?
An emergency fund does what it says on the tin. It’s typically a bank account where you keep a pot of savings that you only use in a financial emergency.
Without an emergency fund, you may find yourself in a position where you need to use a short-term loan to cover your essential expenses.
Having an additional pot of savings during a difficult time can give you the breathing space you need to arrange a lower interest loan or seek financial solutions that don’t involve further debt.
It can also help you to avoid removing money from your long-term investments to cover any immediate shortfall, which may affect its potential for growth.
How much money should be in an emergency fund?
The amount of money you should keep in an emergency fund is a very personal decision. The main factors to consider are the stability of your income and your essential monthly expenses.
When it comes to making your decision, consider:
How long you want your emergency fund to last
As part of this step, you should think about your appetite for risk, the likelihood of your income decreasing (for example, losing your job or needing to work reduced hours) and, should this happen, how long it might take you to return to a higher salary or find another job.
This can be difficult to do, as it requires you to consider the worst-case scenario. Even then, these things are hard to predict and often happen when you least expect them to.
For example, what if you needed to take time off work due to ill health? While none of us like to think it will happen, it's important to make sure your income is protected if you were suddenly unable to work.
While an income protection plan is an obvious way to safeguard your salary while you get back on your feet, an emergency fund can provide extra peace of mind in the short-term.
How much you spend each month on essentials
Working out the cost of your monthly essentials will allow you to calculate the amount you'll need to span the timeframe you established in the first step. You can do this retrospectively or prospectively.
Retrospectively, you could analyse your bank statements from the last few months, highlight your essential costs and create an average. Remember to consider any expenses that are less frequent, such as annual insurance bills. This will give you an idea of your essential costs.
The second option is to prospectively calculate – in other words, budgeting. The downside is that this option is more subjective and allows you to be optimistic when predicting your costs.
Where should an emergency fund be kept?
This question may sound like a simple one to answer, but knowing where to keep your savings can be surprisingly complex. There are hundreds of bank accounts to choose from, meaning the decision can be overwhelming. However, there are a number of factors you can focus on.
Firstly, the account you choose should allow you to access your money straight away. You don’t know when a rainy day may hit, and if it does, you’ll probably need your money there and then.
Secondly, consider the stability of the account. This means making sure your money is safe and isn’t going to lose its value. Put simply, you want to make sure that when you need your emergency fund, it’s all there.
Most bank accounts in the UK will be signed up to the FSCS scheme, which insures your deposits up to £85,000. However, it’s best to check you’re protected, just in case the bank goes out of business.
Finally, consider the interest rate for the account that you hold your emergency fund in. Your funds may be quite substantial, particularly when you’re working, so it’s a good idea to make sure you’re putting your money to work.
When should an emergency fund be used?
An emergency fund should be used for its intended purpose – a financial emergency. This means resisting the temptation to dip into your fund for routine expenses (such as food or travel costs) and, where possible, increasing the amount you save should your salary rise.
If a financial emergency does arise and you need to use your funds, it’s a good idea to continue saving once you’ve paid off any unplanned expenses. Remember, a small financial cushion is better than no financial cushion at all.
This guide was adapted from an original article written by Dr Richard Chater.
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