The emergency fund

Dig your well, before you’re thirsty.

— Harvey Mackay

What is an emergency fund?

An emergency fund is a ‘pot’ of money, that you save up, which, if an emergency should strike, you can use to end the emergency without damaging your finances.

An example would be that you have £2,000 saved in an emergency fund. When you wake up on a cold winter’s morning and jump in the shower, you’re met with a downpour of freezing cold water. Your boiler’s knackered. You call a plumber and he or she tells you the boiler needs to pass on to the afterlife of the local tip. Meaning you need a new boiler. They tell you the cost of a new boiler and fitting will be £1,200. It’s time to crack open the emergency fund.

Now, imagine of hearing it will cost £1,200, and you don’t have an emergency fund. What’s your options?

Borrow from a family member or friend? – Nightmare. To repay £1,200 will take months. The relationship won’t last that long. And what if the family or friend has their own emergency and now can’t solve that because you borrowed off them? I always say, “Once a borrower off friends and family, always a borrower off friends and family.” I know a fifty-year-old man that still constantly borrows from his retired mother.

Use your current monthly salary? – Difficult. Unless you’re earning a large salary and have a handle on your expenses which leaves you £1,200 over each month, this isn’t going to happen. And even then, that month will be one hell of a long month.

Stick it on your credit card? – Never! Only a desperate fool would do this… Which, yes, we’ve done things similar, believing we’ll pay it off before the statement arrives. And we never do, so the £1,200 has interest whacked on it, and it takes months, maybe years to clear the balance, resulting in the £1,200 costing £2,000+. Plus, the psychological knock on could be horrendous. Once you’ve got debt on your credit card you then say to yourself, “Well, I’ll use the card to put petrol in the car. It’s only £50.” And before you know it, that card is maxed out and you’re in serious water.

Get a payday loan? – Hell… Utter hell. See credit card above and times the situation by one thousand. Payday loans are the last stop of the completely desperate and financially naive.

Get finance from the boiler company? – No! That’s what they want. Now they’ve got you.

There are probably another hundred options to go with the above. But, whatever the option, there’s nothing better than the emergency fund option.

Why is the emergency fund such a good option?

Using your emergency fund to solve an emergency is the only option for dozens of reasons. Below are some of the best reasons.

Avoid debt. By using your emergency fund to solve the boiler issue means you don’t get yourself into debt. Debt is, by far, the killer of your financial life. If you go into debt you have to pay it back, almost always with interest; meaning that £1,200 costs more. It could cost you hundreds of thousands of pounds more. Going into debt is like opening a tap. Before you took debt, the tap was shut off tight. Not a drop came out. Now, you’ve loosened that tap, and water is dribbling out. Next month you don’t pay the debt off and the minimum payment at least needs paying, so the tap opens some more. Then the psychological knock on happens and you add more things to your credit card, day to day things like petrol, shopping, a Saturday takeaway. Before you notice the tap’s fully open and debt spills out everywhere. Unfortunately, the plumber can’t help with this. No. The answer is to use your emergency fund.

Maintain credit score. Now imaging you start missing payments, maybe default on a loan, and two huge geezers called Biff and Thump arrive at your house. Your financial self is ruined. What will the neighbours think? What will you think? Plus, your credit score plummets, so forget about getting a loan in the future for the next emergency. Your financial self is toxic. No. The answer is to use your emergency fund.

Preserve your well-being. With the above going on, you won’t be feeling like you’re beside the pool bar having a pina colada on an early summer evening in Greece. You’ll feel awful. You might not be able to sleep, you might not be able to work, you might fall into a funk and your relationships with family and friends might suffer. Imagine the above happens. You could lose your job. Once your health is impacted you can’t put a price on it.

No. The answer is to use your emergency fund. If you use it you won’t sink into debt; nor damage your credit score, so you can still achieve those financial goals, such as buying a house or going on holiday; and not get sick through worry. It’s an old saying but true, nothing is as important as your health. By using your emergency fund, actually the reverse will happen. You’ll feel great for not having to worry about the emergency, as your emergency fund covered it. You’ll feel, and rightly so, proud of yourself. You had the foresight to squirrel away the money in the past to help deal with today. That is being financially mature.

And, what’s so strange about the emergency fund is, and I paraphrase the great Financial Planner Pete Matthew here is, “Once you get a pot of money saved away for a rainy day, it suddenly stops raining and is always sunny.” It’s a bit like a small invading army deciding not to attack a country that has a huge army with lots of weapons. It won’t win.

How to build an emergency fund?

The emergency fund is the keystone to financial freedom. If you can achieve this, you can do anything with money. You can become rich. Yes, rich. But, on the flip side, if you can’t achieve this, everything else, such as budgeting, paying off debt, getting protection like life insurance, buying a house, saving into a pension, and investing your money almost certainly cannot happen, meaning you’ll never have financial freedom. You are not poor, you’re poor with money. There’s a difference.

I see an emergency fund based on levels. A bit like a karate student has different belts. They start with a white belt: inexperienced, then move through the different coloured belts until the black belt: experienced.

Level 1: £100

The first thing you need is a pot to put your money in. So, go and open some type of savings account. It can be a regular savings account from a bank, a bit like a current account. Or, my recommendation would be open an instant cash ISA. An ISA is an individual savings account. Most banks do them, and if you bank online you can probably get one with your online banking or via your mobile banking app. The great thing about ISAs are that they’re tax-free! Thank you government. Every year you can add £20,000 into the ISA. The interest your money makes in the ISA does not get taxed by the government. You can open an ISA with as little as £1. I actually lent someone £1 to open an ISA as they didn’t even have £1. Seventy days later they had £550 in there. Now that’s financial focus. (Note: just using a regular savings account can also provide tax free money, due to your personal savings allowance. I don’t know too much about this, but read up on it if you don’t want to use ISAs from the amazing website The Money Advice Service.

If above fills you with dread, as you’ll worry about what ISA to get, what interest rate etc etc, then don’t worry. On instant cash ISAs, the interest rates are woefully low, so whichever one you get won’t make much of a difference. Plus, once you become more financially aware you can shop around for a better ISA at a later date. As of now, the goal is just get an ISA. It’s like painting the garden fences. If you don’t at least buy the paint, there’s no chance you’ll paint them. The ISA is like the paint. If you don’t have one you won’t save into one.

Okay, you have the instant cash ISA, here comes the tricky part. Put £100 into the ISA. For some this might not be a lot of money. For others, this might be a fortune. I feel the roundness or £100 smackers has a finite feel to it. Even if you took out £1 it wouldn’t look right. £99 is just not as elegant as £100.

If you can put £100 straight into the ISA, then great! Well done. If you can’t then you need to focus on the next pay day. This can be done by budgeting. There are loads of fantastic blog posts about budgeting out there online or in books at the library. You should read those immediately after this.

The only way to really make sure you will put £100 into the ISA is to automate that process. By this I mean set up a standing order to automatically take £100 from your wages, as soon as you get paid, and put it in the ISA. Again, there are loads of information about automating money that you should go off and read. You can probably set the standing order up online or via a mobile banking app. Or you can call the bank or visit a branch. But get it automated with a standing order. If you don’t, there is little chance that you’ll manually transfer this £100. Think about it. You’ve never done this before, so why would you now all of a sudden become a person who has the strength to move the money manually? Automate it. Then once the money has been moved into the ISA, sit back, open your mobile banking app or look online or go to the bank and ask for a statement and marvel at that beautiful £100 in the emergency fund, and say to yourself, “I did that.” This is the beginning of becoming financially free.

Level 2: £200

Last time you put £100 into your emergency fund. Maybe the hardest part was not putting it in, but keeping it in there and not touching it. An emergency fund isn’t a lucky dip fund where you’re in and out of it more times that the hokey cokey. It is there for emergencies. A pizza on a Friday night because you worked late is not an emergency, no matter how starving you are.

Now, level two is £200. A £100 isn’t to be sniffed at, but £200 is twice as nice. If you set up automated savings with a direct debit, then money from your salary should have gone straight in. If your ISA balance is under £200 then keep focused and wait until the next pay day or the next until you get £200 as a balance. If you are already at £200 or maybe a bit more, then great. Don’t touch it. Keep focused.

Level 3: £500

The next step is £500. That’s a lot. It’s half a thousand pounds! But what an emergency fund you will have if you have £500 in your ISA. That’s the type of savings that can hold off quite a big emergency.

If you’re automatically saving £100 a month then it will take you five months. Is that a long time? Depends how you look at it. At the moment it is a long time away. But when you hit the five-month mark and you see £500 in your ISA, then the time will be worth it.

To become financially free a skill you need to learn is delayed gratification. That means you hold off something today to enjoy it in the future. An example is, imagine you’re going on a day-long hike. You’d never drink all your water at the start of the hike because you know that in a couple of hours you’ll be gasping for water. It’s the same with saving money. You make sacrifices now so that the future you can have a nice life. One of the most famous and successful investors of all time, Warren Buffett said, “Someone is sitting in the shade today because someone planted a tree a long time ago.”

If you are automatically saving more than £100 a month then you’ll get to the £500 mark quicker. But either it takes longer than five months or less than five months you’ll end up with the same result: £500 in an ISA. Plus, don’t forget the savings in your ISA creates interest. Free money! Unfortunately, at this amount of money and with interest rates so low it will be a matter of pence. So maybe hold off Googling for personal butlers for the time being. Still, free money is free money. And that interest compounds. Look up compound interest to understand the greatest friend you’ll have in your financial life.

Level 4: £1,000

The big one: £1,000. Here you make a conscious decision to either stay the way you were before you started the emergency fund or continue with changing your financial life. You can opt to stay broke, or in debt, never having enough, always overspending, always borrowing, always worrying about money, always destined to be poor with money. No matter what your age, if you’re twenty or seventy, you have a long time ahead of you. And to continue to live how you used to is no picnic. Or, you can make the conscious decision to become financially free. To take responsibility of how you deal with money.

If you reach level four and get £1,000 into your emergency fund, then there’s no stopping you. You’re doing better than not thousands, not hundreds of thousands, but millions and millions of people. In his book The Automatic Millionaire David Bach says, and I paraphrase. “4 out of 10 American’s are so poor with money they can’t get hold of $400.” That’s over one hundred and thirty million people! Build up the emergency fund to £1,000 and for once, you’re ahead. It might take time. 10 months if you automatically save £100 a month. But that’s okay because you’ll have £1,000 in your emergency fund… Now, if you’re saving £200 a month it will only take 5 months. If you’re saving £333 a month, you’ll be there in 3 months. The more you save the quicker the emergency fund builds.

How much is enough?

How much do you need in an emergency fund? The best way to calculate this is, count up every expense you have: rent or mortgage, gas and electric, council tax, phone bill, internet, petrol and an average food cost. etc. Add them all up. For an easy number, let’s say it’s £1,000 a month. You need, at least 3 times that: £3,000. So, if something terrible should happen, like you lose your job, you have £3,000 in the emergency fund to weather the storm until you find a new job. That three months stops you going in debt. Great! Plus, stops you missing payments and killing all your good credit score work you’ve done in the last couple of months. Three months’ expenses is the minimum. My recommendation would be to get to six months’ worth of expenses. That’s £6,000. Sounds like an impossible figure at the moment. But once you get in the habit of automatically saving, it will become easier and easier. There’s also numerous things that can be done to speed this up and increase your contributions to your ISA, such as spending planning (fancy word for budgeting), getting out of debt, increasing your income, calling your providers and getting a better deal etc etc.

And why is six months better than three months?

The obvious answer is more money is better. The subtle answer is, imagine you have three months’ worth of expenses saved in your emergency fund. You lose your job and it takes you three months to get a new one. You’re back at square one, £0 in your emergency fund. And what if it takes four months to get a job? You’re in debt, a land you vowed never to enter again. But if you had six months’ worth of emergency fund and it took you three months to find a job, well guess what? You’ve still got three months’ worth of expenses in your emergency fund. If an emergency comes up, you can handle it.

And, of course, you could say, “Well, what if I don’t get a job after six months?” And that is true, but it’s less likely to happen. I know of some people that have two years’ worth of expenses. Whatever makes you sleep easier at night is the target you should aim for. I have one year’s worth. I sleep like a king. Notice I didn’t say sleep like a baby, any of you who have children know babies don’t sleep.

In summary

  • An emergency fund is a pot of money that you save.
  • You only withdraw money from the emergency fund in a real emergency, such as you lose your job.
  • You do not withdraw for things like a night out for someone’s birthday, a holiday, you want a shiny new car, you are too tired to cook so you order a Chinese takeaway.
  • An emergency fund is the keystone to your financial freedom. If you can achieve an emergency fund, then you develop the habits and focus to become rich.
  • An emergency fund actually wards off emergencies.
  • An emergency fund stops you going into debt.
  • An emergency fund stops you missing payments.
  • An emergency fund is held in an account where you can get instant access to it, such as an instant cash ISA.
  • An emergency fund should be built in levels, one small step at a time. Achieving small targets, little but often.

Conclusion

As you can tell, here at Pound Pence we’re huge fans of the emergency fund. The reason being we’ve seen it work. It really does do all of the above. People have gone on to becoming financially free. And it all started with an emergency fund.

Now let’s say your emergency fund of six months’ worth of expenses is £5,000. The last question I leave you with is this. How would you feel right now if you had £5,000 in an ISA, sitting there building interest, and protecting you from practically every financial scare life can throw at you? It would feel pretty good, right? Then go and do it, so that the future you can experience that feeling.

Author: The Pound Pence Team

We're Garry and Dave, and we're addicted to talking about money. We want to help as many people as possible become financially free by setting financial goals, getting out of debt, building an emergency fund, saving into their pension, buying their own property and investing for the long term over many decades. We don't do get rich quick, but we do get rich.

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