Managing your money in the current climate may be taking up more brain space than it ever has before. Here at The Next Step, we’re here to help you manage your money effectively, including tips for creating an emergency fund to provide peace of mind when the unexpected happens.
Building up an emergency fund may not be at the forefront of your mind when studying or starting work. Having recently been where you are now, Dr Richard Chater shares his top tips for starting an emergency fund – from why it’s important to what to consider.
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 – for example, an unexpected payment or a loss of income.
Here I set out a framework for what an emergency fund could look like, as well as a rationale for using one. As always, everyone’s situation is different and it’s important to do your own research, so please read this article through the lens of your own circumstances.
Why set up an emergency fund?
Room to make the ‘right’ choices
Sometimes it can be cost-effective to spend a larger amount of money on certain items, and an emergency fund can help you to pay for those items. For example, purchasing a reliable car rather than a cheaper alternative, or buying essentials in bulk to bring down the overall cost.
It may also provide the financial security to be able to accept less job security for a higher salary – for example, locuming for a year or taking a chance on a business venture.
Peace of mind
Money can be a significant stressor, with finances often quoted as the top cause for marital conflict. Having a well-stocked war chest can help to minimise this stress, giving you a bit more breathing space when times get hard.
A buffer against debt
When times get tough, there are some costs that aren’t optional. Without an emergency fund, people can easily find themselves in a position where they have to use short-term loans to cover their essential expenses.
An emergency fund gives you a head start during difficult times, so you have more time to find solutions that don’t involve further debt, or time to arrange lower interest debt.
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 when making your decision are the stability of your income and your essential monthly expenses.
When it comes to figuring out your emergency fund, consider these two steps:
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 may take you to return to a higher salary or find another job.
I appreciate that this is a difficult thing to think about, as it requires you to consider the worst-case scenario for yourself. Even then, these things are hard to predict and often happen when you least expect them to.
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 that you established in the first step. You can do this either 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 the simplest one to answer, but it can be surprisingly complex. There are hundreds of different bank accounts to choose from, meaning the choice 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, as you don’t know when a rainy day may hit. If or when it does, you may 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.
On the subject of stability, 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 on the account that you hold your emergency fund in. Emergency funds can be quite substantial, particularly when you’re working, so it’s a good idea to ensure that you’re putting you money to work – especially when some accounts are paying up to around 5% interest.