How and why you should build an emergency fund

Give yourself the platform to improve your financial outcomes

Building an emergency fund is the most life-changing rung on the personal finance ladder. 

This is because it gives you the security to withstand the knocks that life throws at you whilst giving you the freedom to make the most of the opportunities that come your way. Once you have one, you’ll feel so much less anxious about money. 

Why and how an emergency fund will change your life

John Lennon once said ‘life is what happens when you are making other plans’ - and the chap had a point.

On a long enough time horizon, anything that can go wrong will go wrong, costing you money. Like your boiler breaking, being made redundant or whatever.  

Having an emergency fund means you can pay for these unexpected but inevitable expenses without bad things happening to you, like going into debt, having to move home etc. 

But it’s not just about protecting yourself from the worst that can happen - it’s also about protecting your upside. An emergency fund allows you to make the most of opportunities.

Imagine losing your job. If you have to get a job right away because you don’t have an emergency fund, then you’ll take the first job that comes your way, rather than be able to wait for the right job. 

It can also give you enough security to start that business you’ve always wanted to try.

And it also means that if something goes wrong you shouldn’t need to sell your investments, so you can benefit from the most important wealth driver around - compounding from investing.

How big should your emergency fund be?

Before we get to the general guidance, let’s look at some data. Money Boat compiled statistics on the average cost of common emergencies:

• Home repairs: £562.10

• Car repairs: £479.09 

• Dental care: £365.33

• Pet costs: £171.44

• School uniforms: £124.78

• Fines: £116.09

According to Statista: 

• Roughly 30% of UK households can’t afford to pay an unexpected but necessary expense of £850. 

• 59.2% of UK adults have less than £5,000 in emergency savings. Of those, 32% have less than £500, including 13% who have no emergency savings at all.  

Most financial wisdom says you should have 3 - 6 months of living costs set aside in your emergency fund. But when you look at the data above, you can see that's a huge, daunting goal for most people so we think about it a bit differently.

We think a good starting point (if you're close to zero) is getting to £1k because this would cover you in most emergencies (as above).

We like the notion of getting to £1k and then starting investing - whilst continuing to bolster your emergency fund - because it means you can build wealth whilst still protecting yourself. This is rather than waiting until you’ve built your defences to, say, 3 months of living expenses before starting investing because that can take ages and be frustrating. 

But please don’t let investing or other activities distract you from working effectively towards an emergency fund of at least three months of living expenses. It is absolutely essential.

Where should you keep it

The point of your emergency fund is not to get you rich (it’s to use in an emergency) so you need it to be easily accessible rather than locked up. But that doesn’t mean you can’t generate a return on it in the meantime. 

One option is to use an instant access savings account with a good interest rate. The main downside is it can be tempting to spend it in a moment of weakness (because it's instant access).

A solid alternative is premium bonds because they are much less easy to spend than cash savings and they generate some return, although less of a return than a decent instant access savings account at the time of writing.

Our Co-Founder Damo keeps most of his emergency fund with Trading 212 because they offer 5.1% (at the time of writing) on cash held on the platform, they pay out interest daily and he can’t spend the money without transferring it out. 

Trading 212 also offer a cash ISA, which can be useful if you have significant amounts of cash that would push you outside of the personal savings allowance. 

But, if you have significant amounts of cash, consider investing it via a stocks and shares ISA (up to the £20k/year allowance) rather than a cash ISA because stocks have historically way outperformed interest in the long term. 

Action steps

• Save until you’ve built an emergency fund of 3 - 6 months of living expenses (use our budget). 

• If you’re only just starting out, aim to get to £1k first.

• Store it somewhere relatively accessible but not so accessible that you use it (unless it’s an emergency) where you can also generate a return.

The swagger you’ll have knowing that if life turns upside down you’ll be ok shouldn't be underestimated, not to mention the freedom of having 3 to 6 months of freedom when it comes to career choices. 

This is not financial advice. The reason it’s not financial advice is because it’s not tailored to you. We are here to talk about the principles of building wealth but if you want personalised help, it’s worth speaking to a financial advisor - you can learn more here. As with everything financial, please do your own research. We really encourage that because no one cares more about your money than you and if you learn the basics then it’s life-changing.

If you purchase a product or service using one of the links above, we may receive a commission. There will be no additional charge for you. Remember investments can fall and rise - and past performance is no guarantee of future results. Other fees may apply. Your money is at risk.