An emergency fund is simply a contingency fund. This is a pot of cash that is kept totally separate from normal day to day cash. As its name suggests, the emergency fund is for emergencies and allows you to pay for unexpected problems and issues without having to dip in to the day to day funds, which may lead to financial pressures, stress, insomnia and relationship problems amongst much more.
There are many different types of problems that can strike. For example, your cooker or washing machine may break down and need replacing or your car may suffer the same fate. These are isolated problems that require large one off payments to sort the problem. The consequences of these isolated incidents, whilst annoying, are not that severe and do not drag on and on.
The largest problems arise when there is a reduction in income and expenditure remains constant. The prime examples include a loss of employment either through redundancy, ill health, an accident or relocation. If you lose your job you still have to pay the bills and survive day to day, even though you may have no income. You will, of course, find another job however this may take some time and you have to ensure you have the cash available to live whilst you are securing future employment or having to recover.
As previously noted, the emergency fund should be kept totally separate from cash that is used for day to day expenditure. The emergency fund should be held in a separate bank account and the only movements on this account should be deposits in to build up the balance to the desired level. It is important the emergency fund is instantly available and that cash can be drawn on demand, therefore do not tie the fund up in an account where the cash has to be in there for a minimum period of time, or where you have to give notice to extract funds. Bank accounts that allow you to draw the cash on demand do not have attractive interest rates so you are unlikely to get a good return on the emergency fund balance. Given the current interest rates, very few banks are offering attractive interest rates so it is not such a problem. Besides, the most important thing here is flexibility and the ability to get the cash immediately when you want it.
Arguably, the most important decision is what level of cash is required in the emergency fund? This is not an easy question and there is no right or wrong answer. Different people have different needs and there are many things to consider when deciding on the size of emergency fund that is right for you.
So, how do you build up an emergency fund? If you are fortunate to have the spare cash available then it is advisable to plough it all in to the emergency fund in one go. However, many people are not this fortunate and these people will have to build up their emergency funds gradually by contributing a small amount every week or every month. The amount to be put in to the emergency fund will vary from person to person however it is important it is an amount you can actually afford to save. There really is no need on living on the breadline and having to go without daily essentials in order to build up your emergency fund. The best way to determine how much you can afford to put away each week or month is to devise a budget which will, if prepared correctly, detail how much surplus cash you will have based on your income and expenditure at the end of each month.
Whatever route you take in building up your emergency fund providing you are disciplined, it should not take too long to build up the emergency fund to the level you require.
Bad luck happens to everyone at some time or another, and it is important to have an emergency fund to cover such instances when they do arise. Consequently, if you don’t have an emergency fund at present it is advisable to start building one up today. An emergency fund should remain intact until funds are actually needed, i.e. there is a genuine emergency. It is absolutely critical that you never dip in to the emergency fund, therefore leaving it sitting in the account untouched.
So, in summary the way of creating, and maintaining, an emergency account is as follows;
1) Identify the level of funds you want to have
2) Open up an instant access bank account in which to build up the emergency fund
3) Make regular payments in to the emergency fund until the desired level is reached. Set up a standing order or direct debit if it helps.
4) Do not dip in to the emergency funds unless it is a genuine emergency