What is an emergency fund?

26 October 2020 | Posted by Henry Collie
emergency fund

On average, 17% of people in the UK will experience an unplanned life-event every year. Most people are unprepared for this, so resort to borrowing money. You don’t have to. Having access to an emergency fund will put your finances ahead of most of the UK population.

What is an emergency fund?

An emergency fund is a stash of money you set aside to cover the financial surprises life throws your way. 

Around 93% of people in the UK hold some kind of savings product, whether that’s a cash ISA, investment bonds or a bog-standard savings account. However, most people in the UK don’t have an emergency fund of more than £1,000, despite how important it can be to have one. 

Neil Stewart, a Professor of Behavioural Science at Warwick Business School, who often researches the psychology behind personal financial decisions, says:

‘…it is scary how few people have a savings buffer in cash that can cover them for even a few months.’
Neil Stewart

In this post, we’re going to show you how you can save money each month, and why it could be important to keep 3-6 months of those savings in an easy-to-access emergency fund.

Why do you need an emergency fund?

Have you ever had to get an unexpected car repair, lost your job, or, you know, found yourself on lockdown amid a global pandemic? 

According to research conducted by the Money Advice Service:

‘…nearly three-quarters of households receive an unexpected bill every year, with a typical cost of £200–400. However, 26% of working-age adults have no savings to fall back on, and a further 29% have less than £1,000 saved.’
Money Advice Service

So, that means 55% of people in the UK could find themselves stuck for cash in an emergency. Can you justify saving even more when you’re already living on a budget? After all, unexpected emergencies don’t come along all that often, right? 

According to the Money Advice Service’s 2018 evidence review:
‘17% of the UK working-age population, or 6.9 million people, experience an unplanned life event (such as job loss, bereavement or serious illness) each year.’ 
Money Advice Service

With a decent emergency fund, you’ll probably feel secure enough to weather any of life’s curveballs. When the inevitable happens, though, what can you do? This is where predatory lending thrives. 

According to BBC News, Consumer Focus estimates that 1.2 million UK people take out a payday loan every year. With interest rates often as high as 1,300% per year, it’s easy to see how this trap can send you into a constant cycle of getting loan after loan.

‘52% of customers said that the [payday] loan was linked to an unexpected increase in expenses or outgoings and 19% said the need was due to an unexpected decrease in income.’

If you take out any kind of loan, even from a reputable bank, you will have to pay interest on your repayments. These interest payments will most likely outstrip any interest you earn on your savings. 

You may think you can just dip into your main savings, instead. That’s possibly a better option than taking out a loan but still not necessarily ideal. Before you decide to do this, check if your savings account provider charges penalties for early withdrawal. 

Thanks to compound interest, your regular savings in something like a LISA should grow exponentially. If you plan to take money out of that, you’re just stealing from future-you.

For example, if you take money from your government-backed, Lifetime ISA, you’ll get charged 20% of your withdrawal—far more expensive than a personal loan.

Plus, we humans are creatures of habit. You don’t want to get into a routine of withdrawing your savings. 

The best option might be to place your emergency fund into an easy-access savings account, which won’t charge you any penalties on withdrawal. 

How much do you need?

A good rule of thumb is to keep an emergency fund of 3 – 6 months in an easy-access savings account. But different people have different needs. Someone who’s self-employed may want more cash on hand than someone whose employer provides great sick pay. 

Think about your own financial situation. If you lost your job tomorrow, how long would it take you to find another? How much money would you need to cover your expenses while searching for that job?

To recap, an emergency fund can help you to:

  • Avoid stress
  • Avoid the debt-trap
  • Feel secure
  • Avoid the debt-trap (Yes, we wrote that twice)

How to build your emergency fund

The general rule of thumb for an emergency fund is to keep 3 – 6 months of expenses on hand at all times. Here we’re going to share some tips on how to save money each month, especially when you’re living on a budget.

1. Save 10%

You could send 10% of your pay to an easy-access savings account every payday. That way, you would never even notice it was gone. Depending on your income, you could try to save even more. Remember, only save what you can afford. There’s no point in saving 50% of your income, only to withdraw it all again, later.

2. App

Banking and finance apps could help you to save for an emergency fund. Have a look around for one which is right for you. Always check to see if they are FSCS insured first. You wouldn’t want to lose your money to a recession.

3. Make a budget

Setting a budget is one of the most important actions you can take, in general. How can you know how much you could save if you don’t know how much you’re spending? You may even find some subscriptions or memberships you never use, which you could cancel and funnel into your emergency pot instead.

Key takeaways

  • Consider keeping 3 – 6 months of expenses available, in preparation for an emergency. 
  • On average, 17% of people in the UK will experience an unplanned life-event every year. 
  • Never take out a payday loan. 
  • Keep track of your budget to help you save more money.

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