As a catastrophist, I’m very good at imagining all the things that could go wrong. Although this means I spend a lot of time worrying, it’s very handy for financial planning. More optimistic people (of whom I’m often envious) tend to assume that everything will be OK. Until it isn’t. Most disasters – such as ill health and unemployment – are completely unpredictable, so it’s important to build an emergency cash fund to protect yourself.
In my last post, I explained the risks of inflation on the value of cash. While this is a significant problem for long-term savings, you still need access to some emergency money. In this post, I’ll help you work out how much you might need and where you should keep it.
How much do I need in my emergency fund?
Well, this depends on your outgoings and what other forms of support are available to you. Hopefully, you’ve read my post on stealth expenses, so have set aside some money for large and sporadic costs, such as boiler repairs and vet’s bills. Let’s look at a few scenarios:
You’re paying off credit card debt – in this case, it might seem sensible to devote the maximum amount to clearing those outstanding balances. However, an unexpected expense or drop in income might force you into borrowing more. Dave Ramsey, squillionaire author of The Total Money Makeover, suggests building a reserve fund of $1,000 (almost £800) alongside your repayments. It’ll take longer to become debt-free, but you’ll have some protection against life events that could throw you off course.
You have heavy financial responsibilities – perhaps you’re the breadwinner, or you have a large mortgage to service. If so, you’ll need a correspondingly large emergency fund, around six months’ outgoings. This would provide a decent buffer if you lost your job or suffered a serious illness. Another option would be to take out appropriate insurance cover. As a financial coach, this is not an area I cover, but I recommend Pete Matthew’s Meaningful Money Handbook for excellent coverage of the types of policy available.
You’re financially comfortable – if you have a partner with a reliable income, or your expenses are modest, you can get away with a smaller emergency fund. Three months’ outgoings might be enough. It could take you longer to recover from a serious blow, but at least you have some time to consider other options.
If you’re finding it tough to put aside extra money each month, take a look at my post on paying yourself first.
Where should I stash my emergency cash?
Given my warning about inflation, you might be concerned about keeping a cash reserve. However, this is an emergency fund, rather than long-term savings that you’re expecting to grow. You could consider it a DIY insurance policy, and the small amount of money you lose to inflation is the premium. Having said that, some banks are now offering rates that match – and, in some cases, exceed – inflation. You need an account you can access quickly and without penalties, so check the terms and conditions for any attractive-looking deals. Equally, you probably don’t want an account you can dip into too easily – so keep it separate from general spending. In Mind Over Money, Claudia Hammond suggests opening an account with a geographically distant financial institution, e.g. a Lancashire-based building society if you’re in London. Although your money is accessible online, it feels further away.
You can earn up to £1,000 in interest before you’re liable for basic rate income tax.1 Given the current derisory interest rates, you’d need a balance of nearly £60K before that would affect you. For this reason, it’s usually not worth using your ISA allowance, as you don’t benefit from the tax-free status. In my next post, I’ll introduce cash ISAs and explain the circumstances in which they might be appropriate.
In the meantime, please indulge in some modest catastrophising so you can protect yourself against life’s surprises.
- For higher-rate taxpayers, the threshold is £500 [↩]