Financial Priority No. 1 – The Emergency Fund

The Emergency Fund - Everything You Need To Know

Shockingly, many adults don’t have enough savings to sustain their lifestyle for just four weeks if they lost their job. Suddenly losing their income or having a large unexpected expense could start the chain reaction that leads to financial devastation.

Massive debt, bankruptcy and even homelessness are very real possibilities.

Scared yet?

You should be. Black swan events can take you out the game. However, these random bouts of misfortune aren’t that random. You can prepare for them.

In this article, we’re going to discuss the importance of an emergency fund, how much you should save and where you should invest it.

Why Save An Emergency Fund?

In my opinion, everyone’s first major financial goal should be to be debt free. Excluding your mortgage and debt used to purchase assets (a.k.a good debt), you should have no debt.

Credit cards, car payments and personal loans are all forms of BAD DEBT that should be avoided at all costs.

Once clear of the dreaded “D” word, your next financial goal should be to save an emergency fund.

If you’ve lived long enough, you’ll know that shit happens: a car accident that wasn’t your fault; the boiler packing in a week before Christmas; job cuts due to company restructuring. An emergency fund, as the name suggests, is a stash of cash that helps to deal with life’s unexpected financial emergencies.

It’s kinda like buying a raincoat. You know with absolute certainty that at some point there is going to be a storm, you just don’t know when. By carrying a raincoat with you all the time, you’re prepared for the inevitable downpour.

Just like a raincoat keeps you from getting soaked, an emergency fund keeps you from going broke.

Building an emergency fund is being financially responsible. You’re refusing to be a victim to your misfortunes, and instead, choosing to proactively deal with them.

Saving a rainy-day fund also builds confidence in your ability to handle money, and you begin to see yourself as someone that’s good with money.

This has a MASSIVE psychological impact on how you react to making money and investing. You’re more likely to continue saving and building your wealth once you’re off the starting line. Having cash in the bank will also make you less tempted by speculative, high-risk investments as you’re not desperate for the unrealistic returns they promise, and you’ll become a better investor.

And perhaps the greatest benefit of having a pot of money set aside is the feeling of financial security it provides – and being free of financial worries is something you can’t put a price on.

How Much Should You Save In An Emergency Fund?

So now you know the importance of having savings on hand, how much should you set aside? Well, there isn’t a one-size-fits-all solution. It varies due to individual circumstances (job market, liquidity of other assets) and risk tolerance.

However, a good benchmark is to save 3-6 months worth of living expenses. Three months is usually enough time to find another job, and six months should allow for most eventualities.

That said, if you work in an obscure field that’s difficult to find employment quickly, or you aren’t willing to take any job during desperate times, then save a larger fund. The question you have to answer is:

“What’s the amount that makes me feel comfortable?”

Consider your personal circumstances, plan for the worst, and set aside whatever amount brings you peace of mind.

My own number is £10,000. It’s equal to five months of my living expenses. I could cut back on spending and stretch it out if I had to. Plus, it’s a nice round number that makes me feel safe.

If you’re not yet on top of your finances, saving six months of living expenses can seem an impossible target. In this case, set a goal of saving £1,000. Having a grand in savings is enough to relieve financial anxieties and make most people feel secure, and it will cover most large bills.

And just to be clear, access to money on credit cards is not the same as an emergency fund. You must have the cash readily available without going into debt.

Where Should You Keep Your Emergency Fund?

Where's The Best Place For Your Emergency Fund?

A good way to answer this question is to look at places not to keep an emergency fund.

Property – Property is an illiquid asset, meaning that it is hard to sell quickly. There is also no guarantee you’ll be able to sell when you need to, and you also must account for selling costs (estate agent, mortgage early repayment charges, tax).

Stock Market – The stock market is highly volatile, and in the short term, stock prices can fluctuate wildly. If you’re forced to sell shares during a market dip to cover an expense, then you may lose part of your original investment.

Under Your Mattress – Holding onto physical cash is not the brightest idea. It puts you at risk of loss, damage and theft, and it also results in you losing money in real terms due to inflation.

So, what options does that leave for investing your emergency fund?

Generally speaking, an emergency fund shouldn’t be thought of as an investment. An investment requires you to lock your money away for a period of time (usually years) with the aim of growing it.

An emergency fund can’t be “invested” as you must have quick and easy access to your money.

Therefore, you should keep your emergency fund in the highest paying instant access savings account, and preferably one that beats inflation.

Admittedly, beating inflation is hard in the current financial climate. Typical saving accounts are offering less than 1.0%, and inflation is currently at a rate of 1.5%.

Don’t fret; the goal of an emergency fund is to have cash on hand for the unexpected, and not to grow the pot. Wealth will come from your investments, which you can plough your savings into once you’ve built your emergency fund.

Action Steps

  1. Calculate how much it costs you to live each month by tracking your spending.
  2. Open an instant access savings account.
  3. Set up a direct debit to automatically deposit whatever you can afford into your savings account each time you get paid.
  4. Once you’ve built up 3-6 months’ essential outgoings, redirect your monthly automatic funds into an investment account.

What’s Next?

Personally, the maximum amount I would have in an emergency fund would be six months’ worth of expenses. Holding on to more cash means you’re missing the opportunity to grow that cash or earn an income from it. So, once you’ve saved your pot, it’s time to start accumulating assets.

But before you do, just a couple of bits of parting wisdom.

If you’re tempted to spend your fund each time you log into your online banking, consider keeping your emergency fund with a different bank. And of course, never dip into your fund for frivolous purchases. The latest iPhone is not an emergency.

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