You have heard grandparents say it and seen it in the media: keep some money aside for a rainy day. But is it really necessary? There are so many other exciting things to do with that money after all!
I could enjoy a luxurious holiday or invest it in the stock market – isn’t the sound financial advice to invest money to grow wealth? If something comes up in the meantime, I could just charge it to a credit card.
The problem is that you just can’t predict the future. You don’t know what’s around the corner so you could bury your head in the sand and ignore it, or you could prepare for it. Many people don’t financially prepare for crises as they don’t know what exactly they are planning for so it can seem rather abstract when compared to saving for a Dh10,000 holiday for example.
However, no one can escape Murphy’s Law, which states that if something can go wrong, it will, and at the worst possible time. I will never forget the week that the car broke down, I had a health issue which required me to top up my insurance and the washing machine stopped working. At the time, I didn’t have the funds to cover all the expenses and had to use a credit card. The stress was real and took a toll on my mental and physical health – to feel you don’t have enough money to cover necessities is a situation that I wouldn’t wish on anyone. It took almost a year to recover from one bad week. Since then, I have sworn by my emergency fund.
Making decisions around what to do with your money is hard, especially when it is finite. This article will outline the purpose of an emergency fund, how to decide how much you need and where to keep that stash of money as well as some bonus tips to protect it.
What is an emergency fund?
An emergency fund is a pot of money kept separate from your monthly bills, savings, and investments. It is solely for the purposes of protecting you in the event of a crisis that requires you to part with cash. This money can prevent you from going into debt or selling your investments at a potential loss to cover an essential expense. It’s important that once you decide how much you want to have saved in your emergency fund (more details on that below), that you aim to build it fairly rapidly and replenish it if you have to dip into it.
What do I use my emergency fund for?
It’s crucial to outline circumstances that require use of your emergency fund before you begin building it, otherwise it can be tempting to use it for non-emergencies (a beach holiday is not an emergency!). It’s difficult to resist the impulse to spend money you have stashed away, so having a clear written purpose for the account can help you maintain discipline. The list of specifics will depend on your individual circumstances, but the general rule that I outline to my coaching clients is that this money is for unexpected events or circumstances that require you to part with cash, the key word being ‘unexpected’.
Common reasons for dipping into your emergency fund include:
unexpected car repairs
loss of income or pay cut
emergency house repairs
replacing essential broken or lost items
health issues or emergency vet’s bills
necessary and unexpected travel
Common situations that your emergency should not be covering:
car insurance and service
monthly bills, such as utilities and internet
It is advisable to save for these larger planned items in another savings account – these are your ‘sinking funds’.
How much do I need to save in my emergency fund?
Most financial advice stipulates that you should save 3-6 months’ worth of expenses in your emergency fund. I think that is a good springboard, but highly generalised advice. I tell my clients your emergency fund total must pass the ‘can you sleep at night?’ test.
This involves evaluating whether the amount of money saved provides you with enough peace of mind to feel secure in the knowledge that you could comfortably cover most financial crises that come your way. Obviously, no one can plan for everything (ahem…Covid pandemic), but if you can pay (or at least cover the deposit) for most common emergencies, I promise you will feel better.
You also need to consider your circumstances carefully. Here is a guide to calculating how much you need in your emergency savings:
First, work out your current income and expenses by tracking the last 6 months of spending. Ask yourself if you were to lose your main income source for the next 3-6 months, how much money you would need to maintain your current lifestyle. This forms your ballpark figure.
Then, think about your job or income source. How reliable is it? Do you have a highly specialised role, or would it be relatively easy to find another job? How likely is it that you may lose your job? How stable is your industry? Do you have other skills or qualifications that you could draw on to earn money if you lost your main source of income? This could be something to work on while building your emergency fund as further security against income loss.
Consider how many people or animals you have who rely on your income. Factor your dependents into your calculation – someone with 5 children and pets will need a larger emergency fund than a single individual.
Allow scope for your liabilities in your emergency fund, such as vehicles and houses. Total the items that may cost you a large amount of money if they break – this should form part of the decision about how much easily-accessible cash to have on hand. For example, a person with 3 houses and 2 cars will need a larger emergency fund than an individual who has 1 house and 1 car.
Finally, reflect on your own personality and financial resources. If you are risk-averse and heavily insured (perhaps you have life insurance, critical illness, and income protection), it is possible that you don’t need such a large emergency fund. Your sources of income will play a role in the total amount too – if you have passive income (income not generated by active work such as royalties or dividends) or multiple sources of income, you could keep less money in your emergency fund. It involves weighing up your entire financial picture to make the decision and balancing that with how much peace of mind money in the bank provides you.
How do I save my
It can be tough to save an emergency fund. Even saving 3 months’ worth of expenses can take time to complete. Calculate the total amount you want to save and divide it over different time periods to see what works for your situation. For example, if you want to save Dh21,000 over one year, you will need to set aside Dh1,750 a month. To save the same amount in two years would take Dh875 per month and to reach your goal in six months will require Dh3,500 a month.
The amount you can save will depend on your income and expenses. The ideal balance is to save your emergency fund as swiftly as possible to build financial security, without compromising your quality of life. It may take an evaluation of spending to see where you can reduce expenses to release cash to save towards your emergency fund.
You may find your motivation fades as the months drag on while you build this essential financial safety net. It is hard to build an emergency fund because you’re not saving for a desirable and tangible goal, such as a holiday or a car. However, keep the peace of mind as your goal – imagine a situation where you know you have ‘financial armour’ in the face of the many arrows life will throw in your direction.
It’s also motivational to use a savings tracker, whereby you colour or mark off incremental steps on the journey to your final goal. I have a free emergency fund tracker available to download from my website leapsavvysavers.com – you can track your progress visually for inspiration.
Where should I keep my emergency fund?
In an ideal world, your emergency fund would be housed in a high-interest savings account. It is too risky to invest this money as the stock market is unpredictable and you don’t know when you will need to draw on the fund. If you need it while the stock market is down, you could be forced to sell at a loss. However, money kept in a bank account not earning interest is being devalued by inflation, which is the rising costs of goods and services by approximately 2-3% a year. Thus, it is a balance between keeping your money in a low-risk account while growing it as much as possible. Here are a few tips to consider when you think about your emergency fund’s home:
Split the money between a few different accounts for added security
Keep some of your emergency fund in the UAE and some in your home country or offshore
Research which savings accounts provide the highest interest and house your money there – mymoneysouq.com is a good website for this service
Keep your money in Government bonds or money market funds, which tend to be low risk and give a small amount of interest
Save some of your money into schemes which offer the chance of winning money, such as Premium Bonds in the UK or National Bonds in the UAE
How do I stop myself from using my emergency fund?
It can be tempting to dip into your emergency fund – readily available and easily accessible money?! Who wouldn’t be tempted? There are a few things you can do to resist the urge to ‘just borrow a bit’ – this can be a slippery slope and you could end up with no emergency fund left.
Don’t keep a card for the account which houses your emergency fund. If you are issued one, keep it in a safe place at home along with the account details. This will put some friction between you and potential purchases made from the account.
Write an easily accessible document which lists circumstances which enable you to draw from your emergency fund. Refer to it before you make a withdrawal or purchase to ensure your reason for dipping into the account is worthwhile.
Reward yourself for reaching and maintaining your emergency fund goal with something that brings you joy.
Even though it may not be the most interesting savings account, your emergency fund provides you with essential financial security which prevents you from taking on debt or selling investments to cover inevitable crises. Nobody can predict the future; in fact, the only thing we do know is that life will throw us curveballs from time to time.
If money could talk, I’d wager a bet I know what it would say: ‘save me now and I’ll save you