Building and maintaining an emergency fund is one of most straightforward components of your financial planning, but also one of the most important.
Last year a Yorkshire Building Society survey revealed that a substantial number of people in the UK are alarmingly unprepared for financial trouble.
It estimated that close to 14 million people have less than £500 in savings. More than 70% admitted to having less than £100 saved up.
Even if you do have a decent-sized emergency fund, it’s important to make sure that it’s working hard for you. A recent Daily Telegraph report highlighted this, revealing estimates suggest that there is more than £1 trillion sitting in accounts that offer a very low rate of interest.
Read on to find out more about why you need an emergency fund, how much it should contain and where you should keep it.
An emergency fund gives you valuable peace of mind
As the name suggests, an emergency fund provides you with instantly accessible money to cover short-term emergencies.
There are a whole variety of unexpected events that could cause you to need to access your fund. These could include emergency repairs to your car, money to help a loved one out of a crisis or to cover your household expenses if you or your partner suddenly lose your job.
If you don’t have a fund in place, the alternative is likely to be short-term borrowing, usually with a credit card. Given the eye-wateringly high levels of interest on most credit accounts, that’s surely an option to avoid if possible.
Having an emergency fund negates that eventuality and gives you valuable peace of mind.
There’s no correct amount to have in your fund
Your financial circumstances are unique so the amount you should have in your fund is very much an individual matter for you.
However, a handy rule of thumb is that you should aim to hold between three- and six-months’ net household income. So, if your total net income each month is £5,000, your fund should perhaps total between £15,000 and £30,000.
With the current cost of living crisis very much at the forefront of everyone’s mind, it may well be that many emergency funds are at the lower end of the scale.
Keep your emergency savings separate
It’s important to avoid the temptation to dip into your fund to cover everyday costs or luxury, non-discretionary spending.
One good way of avoiding this is by keeping your emergency savings totally separate to other household accounts. So don’t simply set up a secondary account alongside your main bank account.
The idea is that your fund is for real emergencies. If you’re having to draw from it to cover day-to-day spending, you need to review your expenditure.
Aim to get the best rate you can
Clearly, an emergency fund needs to be instantly accessible. If you have an emergency, you need the money there and then, so it will normally mean an instant access savings account.
However, inflation can eat into the purchasing power of your money. An inflation rate of 10.1% means something that cost you £100 last year is likely to cost you over £110 now. So, the better the savings rate you can get, the less the deprecation in the real value of your money.
Many high street bank accounts will pay you a derisory rate of interest, but shopping around could find you a better rate while still having instant access to your money should you need it.
For example, as of 16 August 2022, Moneyfacts report the best instant access savings account rate is 1.67%. This will give you £250 gross annual interest on an emergency fund of £15,000.
Don’t hold too much in your fund
It’s good to save, but for anything beyond a standard emergency fund amount you should be looking to get better returns than you’ll get from an easy access account.
However, how you invest it is dependent on when you’ll need it.
If your time frame is five years or more, then you should consider investing your money rather than putting it into interest-bearing savings.
Clearly this carries an element of risk, but a longer timescale means longer to ride out inevitable market fluctuation and turbulence.
Remember, you should always try to maximise your annual £20,000 ISA allowance when you’re saving and investing money. ISAs are a highly tax-efficient way to save as you won’t pay Capital Gains Tax or Income Tax on any interest you earn or returns you make.
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The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
This article is for information only. Please do not solely rely on anything you have read in this article and ensure that you conduct your own research to ensure any actions you may take are suitable for your circumstances.
All contents are based on our understanding of HMRC legislation, which is subject to change.