Why do you even need an emergency cash reserve?
Things will always break down. In fact, some things are designed so that after a certain amount of use they will break down and you need to buy a replacement. Wikipedia defines this as follows: planned obsolescence in industrial design and economics is a policy of planning or designing a product with an artificially limited useful life so that it becomes obsolete (i.e., unfashionable, or no longer functional) after a certain period of time. The rationale behind this strategy is to generate long-term sales volume by reducing the time between repeat purchases (referred to as “shortening the replacement cycle”). It is the deliberate shortening of a lifespan of a product to force consumers to purchase replacements.
Look, your car will malfunction, your boiler will stop working and at some point, you or your partner will lose their job. If you don’t have some cash set aside, then you will have a big problem once something like this happens. These events can be expensive, stressful and a massive pain in the backside.
Fixing your car or replacing your boiler might cost £1,500 and finding a job could mean months of unemployment and many interviews until new gainful employment is found.
Things can get even worse (sorry). In the broken car scenario, you still need to get to work. If you’re unable to get to work, then your earnings are likely to reduce, which creates additional financial hardship. You’re also unable to pick up the kids from school and need to ask a friend or relative for help. You might have to take a taxi or an Uber to work instead and this is a new unwelcome expense.
If your boiler breaks down and you have no warm water, then you can’t enjoy your morning showers any more. Imagine you suddenly had to take cold showers until your next paycheck. I tested having a cold shower the other day and survived, but it was unpleasant. Now, throw in some children into the cold water situation and you will see how important it is to get the boiler fixed as soon as possible.
If something similar has happened to you, then you’ll know that it’s difficult to go on with your life as you normally would if you don’t have any cash set aside for the what-ifs of life. Having a pot of money tucked away for emergencies provides you with additional peace of mind knowing that you will be financially OK if something were to break down or you lost your job or something similar.
There are other benefits – for example, having set aside 6-12 months’ worth of your normal expenditure, will provide you with a “financial runway”. You will feel more at ease if you hear rumours that they might start making people redundant at work. Having some savings set aside might also give you enough confidence to start out on a new business venture because if it fails, you will have enough money to sustain yourself throughout a lengthy job search. That new business might be your ticket to happiness and financial security.
Ask yourself, how much “job security” do you really have? Most people have a 30 day notice period at work. What about sickness? How long will you get paid your full salary if you can’t go to work for a few weeks? Is statutory sick pay going to be enough? How safe do you feel? Do you already live payday to payday?
An emergency fund is also important for people in situations where they end up in abusive relationships. It’s difficult to leave and start your life again somewhere safe if you have no money to your name. I’m not an expert in this area and don’t know about all the things you need to consider before leaving an abusive partner. However, I’m sure money would help with that.
There are occasions when you need to suddenly drop everything and travel somewhere. I hope it never happens to you, but you could need to travel for a funeral because of a death in your family. You might need to buy an expensive flight or train ticket on short notice. There might also be accommodation costs and potentially a reduction in your earnings as you’re away to be with your family. That would be a difficult time for obvious reasons and adding money worries would only make things worse. It doesn’t have to be like this.
As you can see there’s plenty of scenarios where having an emergency fund is the solution. It’s not the only solution, but it’s the best in my opinion. You could probably borrow some money or use your credit card etc but these could create further problems if you’re unable to service the debts. It’s a slippery slope and I’d steer clear from that path. The emergency fund is a much better solution as it doesn’t have any big downsides.
There are a few things you should consider before you start an emergency fund. This post will tell you what you need to know to make sure you build up an emergency reserve so that you are in a good position when things don’t go as planned.
So, what do you need to keep in mind before starting to save for an emergency fund?
First of all, if you’re already struggling with debt, have maxed out all your credit cards and owe money to your friendly neighbourhood loan shark, then this post isn’t for you (but I’m glad you’re reading it). You’ve got bigger fish to fry and should not be thinking about having an emergency fund. You need to prioritise paying off your debts. Seek debt counselling from a reputable charity if need be. Godspeed.
If your financial situation is better and you are OK with paying all of your bills and have some extra money each month, then you are in a good position to start saving. It’s important to realise that you need to dig your well before you’re thirsty. This means that you have to plan before the emergency happens. If things are good at work and you’re healthy etc then now is the best time for you to start building an emergency cash reserve.
How much do you need to save for emergencies?
There are many numbers thrown around on the internet and everybody will give you a different figure. It’s quite subjective but 3-12 months’ worth of your normal expenditure should do it. So, if you spend £2,000 per month, you should aim to save up at least £6,000 for your emergency fund. If this sounds too hard, then you could look at what your essential outgoings are and cut out all the excess. Say it’s £1,500 per month. In that case, you would need a cash reserve of at least £4,500.
If saving up 3 months’ worth of expenditure is too difficult, then aim to save as much as you can. One month’s expenses saved up is better than nothing. It’s important to start the saving habit.
The upper end of 12 months is also subjective. You could opt for more if you wish and this is a personal decision based on how much safety you want to have in life. I think you need to be a bit wealthier than the average Joe to have more than 12 months’ worth of cash set aside for emergencies.
It’s important not to treat your cash reserve as a miscellaneous savings pot. You should not dip into this pot to fund your holiday, buy a new electronic gadget or spend it on booze and cigarettes. This is important and you will be very glad you have this money set aside when you need it. The purpose of this money is to have insurance. That’s how all insurance works – you buy it precisely because you don’t want to ever have to use or need the sum assured.
Where should you keep your emergency cash reserve?
Simply put: in the safest place you can think of. If you don’t trust the banks, keep it under your pillow. If you think somebody will find it under your pillow and run away with it, then keep it in the bank. If you’re worried about both of these then diversify.
The main criteria to look for are ease of access and safety. I mean, don’t lock it away for 12 months to earn 1% of interest on it. Remember, this is money you need to have access to at a moments notice. This is an emergency!
You could open a second bank account to keep these monies separate from all your spending money. One option is to consider opening an account with NS&I as well because they are backed by the UK government. I’ve created a short video below about the different products available on NS&I.
NS&I is essentially a way for you to lend to the government and earn some interest in the process. Your bank might go bust but the government is quite unlikely to go bust (especially here in the UK as the government can simply print more pound sterlings left, right and centre). Therefore, your monies in NS&I will be very safe. You could choose from several products such as Premium Bonds for example. Have a browse on their website. A lot of people like having Premium Bonds as these receive “prizes”, where the maximum could be £1 million. Effectively, you’re getting lottery winnings rather than earning interest with Premium Bonds. Please note it can take a couple of days to get your money out of NS&I. One option to consider is to keep a few thousand pounds in a bank account, keep some in cash at home and the rest of your emergency fund with NS&I. It doesn’t have to be all-or-nothing.
Should you invest your emergency cash reserve monies to improve the return you can get on it?
You might be tempted to invest your emergency fund instead of keeping it in cash. It’s true, interest rates are at all-time lows and you could make some sweet-sweet gains in the stock market if you YOLO it all on Tesla stocks or buy a few good old Bitcoins. After all, you could just sell your investments and then have access to your money. It will take a few days to withdraw the funds into your bank account, but it’s fine you say to yourself. The problem with this approach is that you might be forced to sell your investments at a bad time e.g. when the markets are down (stock markets crash every decade or so). Right now (during the Covid-19 pandemic), would be a bad time to sell investments and realise your losses but you are dealing with an emergency.
There’s another danger with investing your emergency monies. You could be unlucky and make investments in funds, which suspend their dealings (this means nobody can buy or sell your investment for a certain time – this is what’s happening to real estate/property funds today for example). Now you can’t even sell. Liquidity (the ease of selling your investment) is important. Cash has perfect liquidity.
If you’re sensible with your investments, then you might be OK using “boring” investments (such as money market funds) for emergency fund purposes. However, I would recommend keeping it in cash. You know what they say – cash is king. Don’t forget you have an emergency on your hands. Keep it simple, stupid!
Emergencies will happen, things will break down and you might lose your job. Build a cash reserve, which will provide a huge help with a myriad of stressful situations. Aim to save 3-12 months’ worth of your normal living expenses and keep these monies in a safe easy-access bank account.
Now you know why you need an emergency cash reserve, how much you need to save and where to keep the monies. Go ahead and start planning for the inevitable emergencies today.