You probably know that you need an emergency fund. It’s mentioned often. You may have heard £1,000, you may have heard 3-6 months. You may have ignored it all and just started investing. Starting an emergency fund is difficult, frustrating and it’s so easy to just stick your head in the sand and pretend it’s not needed.
It’s even harder during this never-ending cost of living crisis. You’ve been fighting for two decades to just keep your head above water as the costs just spiral upwards. You’re finally able to scrape some money together to start investing and someone like me comes along and says put it in a cash ISA as an emergency fund. It knocks all the wind out of your sail and is the most discouraging advice you can get when starting out.
It’s even really vague advice: three to six months. Is that everything I spend? Just my absolute expenses? Can I get away with three months? You need a framework so that you know how much you need, so you don’t end up with far too much or far too little.
I’ll show you why this most annoying of necessities is actually required, and how much you need.
Why an emergency fund exists at all
Why do we need one?:
An emergency fund is the money you never invest, so the money you do invest can stay invested.
It’s not there to make you your fortune, it’s not even there to make you a profit (in fact, it usually makes a small loss). It’s there to be boring, reliable and there when you need it. It’s there as a shock-absorber for your life, so that bad things that happen to you don’t force you to destroy your investments.
These things are unpredictable as individual items, but they will happen. A job loss, broken boiler, broken car. These can come out of the blue and completely destroy your lovingly crafted plans. Markets fall roughly 20% once every few years and more than 40% once or twice a decade. You don’t want to be forced to sell out during one of these crashes.
The problem with “3 to 6 months of expenses”
The standard advice for how much you need is 3 to 6 months. I’ve probably used it myself elsewhere on this site. It’s a good rule of thumb and it shows that you need a serious fund to cover some big emergencies, not just enough that you can cope if you have a minor issue.
The problem is it’s horrifically vague. Is this everything I spend, or is it OK to live off porridge for those three months? My partner has a job; do I assume that they’re working or that they’re out of work too? How do I know whether three or six months is right? What if there’s a lot of Lego I really really want; can the emergency fund wait a bit?
In reality a single parent of two renter working as a contractor has very different needs to a married couple with no children both working ‘safe’ government jobs. I’ll try to make it clearer, so you can work out what’s right for you.
Working out your number
The standard 3-6 months is a such a huge range as to be as confusing as it is helpful, so I’ve made it more of a framework you can follow.
Work out your essential monthly outgoings
Picture yourself in crisis mode. You’ve just lost your job, the rent is due soon and you’ve just broken your leg. What could you cancel and what would you be forced to keep paying? This crisis mode spending is what you need to get 3-6 months of. Don’t forget your annual costs.
These could be rent/mortgage, council tax, minimum debt payments, insurance, groceries, heating. Ignore anything you could do without, like takeaways, date nights, holidays and netflix.
Some example numbers to help you:
| Category | Normal mode | Crisis mode |
|---|---|---|
| Rent (room in a shared flat) | £650 | £650 |
| Council tax (share) | £75 | £75 |
| Utilities | £80 | £70 |
| Phone | £20 | £20 |
| Groceries | £200 | £150 |
| Transport | £100 | £40 |
| Subscriptions (Netflix, gym) | £45 | £0 |
| Social / meals out | £180 | £0 |
| Coffee / work lunches | £80 | £0 |
| Clothes and personal care | £60 | £20 |
| Other (e.g. gifts, misc purchases) | £60 | £30 |
| Savings and investment | £100 | £0 |
| Total | £1,650 | £1,055 |
This is not an enjoyable amount to live on, there’s no room for luxuries of any type. It’s by design the bare minimum you can get by on, to give you some time to get a solution to your crisis. It allows you to take your time and find a good solution, rather than getting the first bad job available, selling all your clothes on Vinted or fire-selling your investments.
Obviously your numbers will be different, and what you can cut down on in a crisis may be different.
Multiply by a factor based on your situation.
So which is it for you: the three months or six? It depends on the kind of life you’re currently living.
The three month line is for a very stable life. We’re talking dual income no kids in stable careers. You then add time for each risk that would make it harder to replace your income or reduce costs when needed.
You’ll want to add a month for any of these:
- Any dependents; this can include children, elderly parents or anyone else who depends on your income
- There’s only one income earner in your house
- You own your own home. Counter-intuitively this adds risk; your essential expenses include the mortgage, but you have the possibility of a boiler breaking, roof fixing or structural repair costs that renters usually avoid.
- You work in a cyclical or unstable industry
- You have a health condition that affects or could affect your ability to work
And two months for any of these:
- Self-employed with variable income
- Commission-based job where your income isn’t guaranteed (e.g. sales, recruitment)
Each of these factors increases the risks of a crisis, or makes them more frequent. The ‘more frequent’ both increases the risk that the fund hasn’t recovered before the next crisis, and the risk that two crises come at once. The more frequent and bigger the crises, the bigger financial bumper you need to cushion the fall.
If you end up ticking three or more factors, you’ll want to add another month, because these risks compound. Losing your job when you’ve got children is much worse because the two affect each other.
You’ll probably end up around the four to six months range. There’s a quiet benefit here; these bullet points generally accumulate as you live your life, so when life is simple you can have a smaller fund, then build it as your situation grows more complex.
Sense check your number at the end. If you’re still anxious after you’ve calculated your number, you can add a month. If your calculation goes past nine months, and you’re not raising eight children alone while working self-employed in a volatile industry, you’re probably being overly cautious and you can drop it down to nine.
Where to keep it
The fund needs to have a safe haven for you to keep it. It needs to be easily accessible so you can get to it in an emergency, but not so easy to access that you raid it when something you really want goes on sale. Preferably you will get enough interest on it so that you’re not losing too much to inflation. A cash ISA or a high interest saving account are usually good options.
Whether Premium Bonds are a good idea or not depends mostly on you. The returns are very variable (it works on a sort of lottery, where your interest is prizes you win), and usually less than a high interest savings account. Your savings probably therefore won’t keep up with inflation, and will need topping up more frequently than a high interest cash account. It also takes a few days to receive your money, making it less useful in a real emergency.
The main advantage (apart from the potential to become a millionaire) is that it feels invested, so you’re less likely to raid it for non-emergency uses. This is not to be dismissed; most emergency funds fail through being raided rather than because the interest rate was too low.
There are a few tempting options that are rarely a good idea:
- Current accounts are the worst of both worlds; low interest and very easy to raid.
- Fixed term bonds: the money’s not there when you need it
- Stock and shares or other investments: you could easily be selling at a bad time, especially as personal emergencies and stock market crashes often come at the same time.
What actually counts as an emergency
An emergency is an event that will cause you personal or financial harm if you don’t use the fund. This can include a car repair (if you need the car for work), redundancy, home repair (NOT renovation). It does not include any type of holiday, sale, Christmas or repairing something you can do without for a while.
I must admit I’ve stretched myself thin a couple of times for such ‘emergencies’ as a Lego set I want retiring. You’re not going to be perfectly disciplined all the time, but we can aim for perfection even if we don’t reach it. You’d have to have stronger discipline than me to tell your 5 year old you can’t afford any gift for them at Christmas when you’ve got five months of expenses in a savings pot and you’re aiming for six..
The problem is if an actual emergency comes straight after your ‘emergency’, you won’t be ready. You can minimise the damage by if you raid it, stop adding to investing and cut back on your fun budget until the hole is repaired.
Can you invest while you build it?
If you have nothing saved, you need to build a fund before investing at all. You need to be able to cope with small emergencies before a penny goes into investments. If your most likely crisis is costs e.g. boiler repair or car repair, £1,000 in an emergency fund will cover most issues. If your bigger risk is job loss, 1 month expenses should be saved before you start investing.
Once you’ve got this small fund, you can do your higher priority investing alongside building your fund. This is getting your employer match for your pension and paying down high interest debt. You want a full emergency fund before you start throwing extra money on your low interest debt or general investments.