An emergency fund is a pot of money you should have available for use if an unexpected bill comes your way. This is one of the most important elements of your financial planning. Everyone should have an emergency fund, but most people do not have enough put aside. If you need cash in an emergency, and this is not available, you might compromise your financial plans. At best, this will put back your plans; at worst this could cause significant financial harm.

This article explores why you should have an emergency fund, and how much is appropriate.

Key points:

• What is an emergency fund?
• Why might you need access to an emergency fund?
• How large should your emergency fund be?
• Consequences if you do not have an emergency fund
• When might your emergency fund be too large?
• How to build an emergency fund
• How our Prosper service can help

What is an emergency fund?

An emergency fund is simply a pot of cash put aside for use in emergencies.

The sole purpose of this emergency fund is to be available should something change in your life dramatically, and quickly. You should be able to easily access your money to plug a short-term gap without resorting to other long-term savings, or borrowing.

You should set up a separate instant access bank account for this emergency fund, put the appropriate amount of savings aside, and forget about this money until it is needed. After that just review the fund regularly to check you still have the appropriate amount saved. We do not recommend that you worry about the interest rate on this part of your savings; the most important thing to remember is that your emergency fund is just there to solve any short-term financial situations.

What your emergency fund is not for

Your emergency fund should be to provide short-term cash for unexpected costs. Your emergency fund is not to be merged with your short-term planned spending. If you have savings for these projects, do not include these savings in your calculations as you will be tempted to think you are in a stronger position than you really are.

If you use your savings for your planned expenditure in emergencies, you will solve your immediate problem by raiding other savings for a more urgent issue. That less urgent planned expenditure will still happen, so by accessing this money you are only really putting off the inevitable.

• Tax bills
  You may have to pay large, planned tax bills. If you are sensible, you gradually save for this liability throughout the year. This pot of money is not part of your emergency fund. It is there for a specific purpose. 
• Holiday fund
  If you have a planned holiday, you will probably save towards the cost, or for expenses while you are away from home. This pot of money is not part of your emergency fund. It is there for a specific purpose.
• Projects
  If you have a planned project such as home renovations, or a new car you may want to save towards the cost. This pot of money is not part of your emergency fund. It is there for a specific purpose.
• Longer-term savings
  If you are saving for the longer term (perhaps in pensions, or ISAs), then these funds are not part of your emergency fund. You will not be able to access these savings quickly, which may not be helpful if you need money to pay for something urgently. You may have invested this money, and there could be unexpected complications if you access the money early such as fees, penalties, or tax. The investment markets may have fallen, meaning that a withdrawal could have a damaging impact on your longer-term plans. This pot of money is not part of your emergency fund. It is there for a specific purpose.

When working out your emergency fund you need to exclude planned short-term expenditure, and any longer-term savings. Keep these accounts separate to be sure.

Why might you need access to an emergency fund?

Your emergency fund is there to provide short-term funds when something unexpected happens. The emergency fund is not designed to solve longer-term issues like sickness, or retirement.

Look at the situations below and honestly answer whether your current savings would be enough to cope with any of these events.

1. An unexpected bill

The most likely need for an emergency fund is an unexpected bill. Perhaps your boiler or car needs to be repaired, or you need to source an alternative. Perhaps you find yourself needing to cover a bill that is not insured. The list could be endless, but if you think back over the last 5-10 years you can probably remember a variety of situations where having a pot of cash to cover this short-term need would have been very welcome.

The Unexpected Costs Report compiled for the Money Advice Service lists a variety of unexpected expenses suffered by respondents. This research was undertaken in 2013, so many of these costs may have increased.

In the survey, 71% of UK households had experienced at least one unexpected cost in the last 12 months (2013). Here are some of the costs listed in the report:

The report also shows that the average respondent reported more than one unexpected bill in the last 12 months. The average reported was 1.61 unexpected bills, with 29% having no unexpected bills, but 44% reporting 2 or more unexpected bills. Households with children reported a higher incidence of unexpected bills, and over 65s reported larger bills than the average.

An emergency fund would allow you to sort out a solution to this unexpected bill quickly.

2. Losing your job

If you lose your job for any reason, you will lose your income. Your income drives your lifestyle expenses, and without this money coming in you will quickly run out of disposable income. Without this money, you will have to start making decisions about your future spending.

An emergency fund will allow you to put off these choices while you look for a new job.

3. Unexpected illness or death

If you are ill for an extended period, you might end up losing your job. At the very least, your income is likely to reduce due to sickness benefits, or state support. The death of a family breadwinner can have equally difficult short-term financial consequences. Even if you have insurance in place, there may be a delay in securing a payout, and assets may be inaccessible while probate is resolved.

An emergency fund will allow you to deal with the unexpected loss of income that results from these situations.

How large should your emergency fund be?

As a general rule you should aim to put aside enough money to cover 3-6 months of household expenditure in an instant access account. Additional planned expenditure (such as tax, holidays, and projects) should be additional to this figure, and separate. If you are cautious (perhaps you are retired) then you may want to put aside more money, but be careful not to have too much in cash as this will lose its value over time.

This amount should be reviewed regularly, perhaps annually, as your situation changes.

If you have guaranteed income, you may need less in your emergency fund. To some extent, the final decision on the amount of cash to hold is a judgement.

Consequences if you do not have an emergency fund

• Spend less or go without
  If you do not have savings available you may have to make stark decisions about whether to spend the money on the unexpected bill. For example, if your boiler needs a repair, how will you fund this cost? Could you realistically go without?

  If you need money for a longer period, perhaps because you have lost your job, then the unexpected requirement could be much greater. This is why we recommend 3-6 months of household spending to be put aside for your emergency fund.

• Borrowing
  Many people are tempted to think that the easy solution is to resort to borrowing. In an emergency you are likely to access expensive short-term borrowing products such as credit cards, overdrafts, and payday lending. The interest payments are very large on these products, which could exacerbate the emergency situation, adding extra monthly costs, and greater expenses through interest. Putting money aside in your emergency fund will allow you to avoid making the situation worse by borrowing.

• Using longer-term assets
  It is also tempting to think that you do not need an emergency fund because you have other savings elsewhere, such as investments or pensions. As mentioned above, if you access these accounts in an emergency you are likely to create other problems such as additional costs, and tax bills. The investments markets may have fallen, and you might not get back what you expect from these accounts. You may also have to hold back your longer-term plans.

When might your emergency fund be too large?

Many people have a good savings habit, but a common “problem” is to have too much in savings accounts. This may make you feel secure, but could have the opposite effect over time. If you have more in savings than is required for short-term projects and emergencies, then the excess is simply not working for you in the long term. 

Holding too much excess cash is likely to lead to low returns on your money, and this interest will probably be less than the growth in the cost of living. Over a longer period you are likely to find that the purchasing power of your cash falls. Read more about the risks of holding too much cash.

How to build an emergency fund

It can feel daunting to build a suitable emergency fund, but here are some basic tips:

• Start a regular savings plan
  Set up a separate bank account, away from your current account that pays your bills. If you set up a standing order from your current account to your savings account to be deducted the day after you get paid you won’t miss the money. If your budget is tight then start with small amounts. You can easily increase the monthly savings as you spend less, earn more, or finish paying off expenditure items. You will be surprised how quickly the savings will build up, and keeping the fund separate from your normal spending should mean you are less tempted to access the money without due attention.
• Pay off short-term debts first
  Generally, it is sensible to pay off short-term debts first, simply because these will cost you money in interest payments. List your debts by interest rate and aim to pay off the maximum you can afford by the most expensive interest rate. When this is cleared you can move the monthly repayment to paying off the next most expensive debt by interest rate. Once all your short-term debts have been cleared you can apply this amount to your emergency fund savings, making this money work for you rather than your lenders.

How our Prosper service can help

If you have more complex financial needs we can help. Our Prosper Service helps you to balance your short-term needs and your long-term financial plans. This balance always includes a recommendation for a sensible emergency fund, but we will help you to put any excess cash to work for your longer-term financial security. You should especially talk to us if you are a high earner or business owner without an emergency fund, or a prudent saver with a large amount of cash savings.