As a basis of all good financial planning I want to stress the importance of building and keeping an emergency fund or ‘rainy day fund’. The expression may originate from the days when casual farm labourers needed to save a proportion of their wages ‘for a rainy day’, i.e. for occasions when bad weather might prevent them from working and earning money. A ‘rainy day’ was, of course, something that a prudent person would expect to occur at intervals in their life even though they would never know quite when. It has negative connotations, although in another context and given the current heat wave, a ‘rainy day’ would currently be a huge blessing.
As a result of its effect on people’s livelihoods and businesses, the Covid pandemic showed us, if we didn’t know before, the importance of having a sufficient ‘rainy day fund’ which I will refer to simply as an ‘emergency fund’ from now on. We are now faced with soaring food and energy prices and rising mortgage rates and if we haven’t yet learned the lesson we are being shown once again how necessary it is to have sufficient emergency funds for our families and our businesses.
The point about ‘rainy days’ is that we must expect them. Very few of us go through life without unplanned financial expenses, both small and large, occurring from time to time. These can destroy our long term financial planning by making us borrow more or sell things at the wrong time if we don’t have an emergency fund in place.
What is a suitable emergency fund?
Financial planners typically recommend that their clients keep an emergency fund of between three and six months of their average monthly expenses. Given the increasingly difficult financial headwinds that we seem to be facing I think it would be prudent to build and keep an emergency fund of a minimum of six months average expenses.
The first thing is to work out your average expenses as this can be a shock to many people. Let’s say you arrive at an average expenses figure of £3,000 a month, then you should aim to build an emergency fund of at least £18,000.
Where do you keep an emergency fund?
As you will need to access this money in an emergency, when your ‘rainy day’ appears, you will need it to be ‘liquid’. That just means easily accessible without restriction or possibility of loss. It will be no use to you in property or shares or other assets you need to sell because there could be a delay in finding a buyer or you may have to sell at a loss. This is especially true if your ‘rainy day’ coincides with a more general ‘rainy day’ for others.
You need your emergency fund to be in cash. It doesn’t need to be in physical cash ‘under the bed’ as that can be stolen. For most of us an easy access bank, building society or National Savings account will do the job.
Your priority is accessibility rather than the best interest rate. You will have to put up with inflation reducing the purchasing power of your emergency fund and top it up as necessary.
How do you build an emergency fund?
You need to look on an emergency fund in the same way that you would look on the necessity of having a foundation under your house. Even if it were allowed by law, there is really no point in building or owning a house that does not have a secure foundation as a ‘rainy day’ is sure to come and undermine the whole structure.
What this means is that when you work out what income you have to live on and what you will spend that income on, you must allow an amount every month to go towards your emergency fund until it is of a sufficient size. Ideally you should also allow an amount every month for medium and long term savings and pensions but that is not my main concern here.
It is important that you know accurately how much you spend at present and on what. You could use the MoneyHelper Budget Planner. If, when you look at your expenditure in comparison to your income, there is nothing left to put towards an emergency fund you need to take positive action to reduce your spending in some other area. This may be painful at first but over time you will get a sense of wellbeing that your financial planning at least has a good foundation.
Of course, once you are faced with your ‘rainy day’ and you make use of some, or all, of your fund, your first priority is to start replenishing it again.
Your family ‘rainy day’ fund
Earlier this year I had a great experience when I was in Almaty, Kazakhstan. I was asked to give a presentation about managing money well to an audience of mainly young Russian speaking Kazakhs. I used a lot of pictures and charts as I thought that would help and together with my lady interpreter my presentation lasted about an hour. It was then followed by a further 90 minutes of questions and we had to close the meeting or we would have been there even longer.
One of the issues that came up is that when someone in a Kazakh family needs money they simply borrow it from another family member who has saved it but then often don’t pay it back. This does not encourage individuals to build their own emergency funds.
As we get older and may have children and grandchildren then we can find that our emergency fund also becomes their emergency fund and in so doing needs to become much larger in size. Over time the best thing we can do for our children and grandchildren is to encourage them to build their own emergency funds. If this email can help in this respect then I would be delighted.
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