Emergency fund

I have read a lot recently regarding the role of the “emergency fund” in the management of our personal finances. It seems that I have some slightly different views from the majority on this matter and so I decided to investigate further.

 

Emergency fund – what is it?

Firstly, let’s agree upon a definition. Investopedia states: “An account that is used to set aside funds to be used in an emergency, such as the loss of a job, an illness or a major expense. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to use high interest debt, such as credit cards, as a last resort. ”. I’m generally happy with this definition.

 

Emergency fund – how much do I need?

Most financial planners suggest that an emergency fund contain enough money to cover between three and six months of living expenses. Again, I think this is a sensible amount as the most significant “emergency” is usually loss of employment and it is reasonable that you would be able to obtain new employment within three to six months.

Emergency fund – what should it look like?

This is where I disagree. The emergency fund is always described by financial experts as “savings”. However, I think this is a mistake for many reasons, especially in the current economic environment of low interest rates.

Let me explain why by looking at two scenarios of net wealth and how the emergency fund would work for each:

 

Scenario 1 – you have debt

Let’s take the example from a recent post on debt repayment. Here, we had outstanding debts of £111,519 (including mortgage debt). By optimizing our repayment strategy (avalanche method), we determined that by paying £1,150 each month we would incur total interest of £44,774.74, fully paying off our debt in September 2024.

Instead, let’s imagine that we first save 6 months expenses in an emergency fund before we start paying back the loans. Our available net income in this post, surplus to the minimum repayments, was £149 per month.

If we earn the UK average wage of £26,500 per annum, and our expenses are 50% of our gross salary, then we need to set aside an emergency fund of £6,625.

This would take 45 months to accumulate our emergency before we could start applying our overpayments to the loans.

Then, we start making our overpayments as effectively as possible. In this scenario, we have now paid £68,331.01 in interest, fully paying off our debt in February 2027.

To make a direct comparison, we can compare how much cash we would have in February 2027.

With the emergency fund option, our cash balance of £6,625 earning annual interest at 2.0% is worth £8,400.

Without the emergency fund, we would be placing £1,150 into our savings every month between October 2024 and February 2027, which (without even considering additional interest) would amount to £33,350.

Therefore, our “emergency fund” has cost us around £25,000 over the period in which we are repaying our debt. For me, this raises one fairly obvious conclusion:

BEING IN DEBT IS THE EMERGENCY!

 

Scenario 2 – you have no debt and are investing

In this scenario, we have no debt and are starting to build up investments (to build our long-term wealth). Most financial planners advise to save 3-6 months emergency fund and after that start to invest. This is the most illogical argument of all when thinking about emergency funds.

If we earn the UK average wage of £26,500 per annum, and our expenses are 50% of our gross salary, then we need to set aside an emergency fund of £6,625.

If this emergency fund is kept in a “checking account”, the most liquid form of savings, this will currently earn around 2.0% per annum interest.

Instead, if we place this amount in stock market, in a variety of FTSE 100 companies, the average returns on the market over the past 25 years is 6.4% per annum, with current dividends at 3.5%. This investment is equally liquid and can be accessed in the case of an emergency.

Therefore, over the same period as in scenario 1, our emergency fund would be worth £8,400 in the current account, compared to £20,550 given the average returns in the FTSE 100.

In this scenario, if we keep our “emergency funds” in the most liquid form, it will cost us around £12,000.

EMERGENCY fund

The key thing to remember is that this fund is for an EMERGENCY. By nature, this is something that we aren’t expecting to happen, but we want to be prepared for in case it does. “It may never happen”. In the scenario 1 above, if we have no emergencies over the course of the debt repayment, we will be £25,000 worse off by holding this emergency fund in cash. In scenario 2, we would be £12,000 worse off. Emergency funds, as they are generally promoted, can be very expensive!

 

What about if we do have an emergency?

You may be thinking that I’m ignoring the point: what if we do have an emergency? Well, the theory doesn’t change.

Currently, interest rates are very low. Therefore, assuming that we have access to a form of easily obtainable credit, which covers the 6 month expenses, I would advise that this should be the form of the emergency fund. 0% balance transfers credit card, 0% purchases credit card, etc. These can be taken out with around a 3% fee. So, if you have an emergency for £6,625 (matching the example above) this would cost £198.75 as a fee. You would then pay off the card before the end of the 0% period, or in line with your other loans in the avalanche system.

 

Conclusion

At first glance, it seems slightly irresponsible to take out more debt for an emergency, but a £200 fee in the case of an emergency is greatly favorable compared to the £25,000 difference noted in scenario 1 above.

We obviously need to be careful to ensure that we have the available credit in the short-term. If you don’t, then you will HAVE to build an emergency fund in cash. However, if you do, and most people do, your “emergency fund” should be (especially in a period of extremely low interest rates) a virtual bank of cash that you can use if the emergency arises.

Also, I would like the repeat the above statement again as I believe it is extremely important: BEING IN DEBT IS THE EMERGENCY!

To explore more ideas like this, and for the greater steps to financial freedom, my book Becoming rich: one step at a time, is now available from the amazon kindle store.