What is an emergency fund and why should I have one?
There is no doubt in my mind that most, if not all of us, have experienced situations either where we have lost our job or been unfortunate enough to be involved in a minor accident. We call these events “curve balls” because they are unexpected and often happen at the worst possible time. These situations potentially have an adverse impact on our income and require access to immediate cash to avoid borrowing on credit cards, which if you recall my previous article, often includes very high rates of interest.
Within financial planning, we often use analogies to help explain how things work and their importance. The analogy I would use in this instance is to liken emergency funds, wills and life assurance, as the foundation of your financial planning in the same way you would put the foundations of your home in first. If you fail to have adequate foundations for your house, it will ultimately fall down, now imagine what would happen if you didn’t have emergency cash for that proverbial “rainy day?”
By having an emergency fund, you are building the foundations of a sound financial plan that will see you in good stead throughout life.
Now you may be wondering how much and where should I keep such cash?
Everyone’s situation is different; however there are general guidelines which I would advocate you following. Look at your total monthly expenses and allow 3 to 6 times this amount to be held in an instant access deposit account. Of course this does mean discipline and restraint is required to avoid the temptations to spend that will come your way. Remember, you wouldn’t remove the foundations of your house, would you?
As professional financial planners, we explain the impact of inflation on your deposit accounts with the bank and it may appear that the above guidance is counter intuitive. Let me reassure you it’s not. The whole reason for having emergency cash is to enable you to plan ahead and take full advantage of investment opportunities such as properties and equities, whilst reducing the risk of having to sell them at the most inopportune time. Just remember back to 2008 when the global financial crisis hit, how many people were over exposed to property investment when they needed cash?
Following on from the emergency fund is the cash reserve. These can be one and the same, but while it is best to have the emergency fund in a no notice type bank account where there is little or no interest paid, money above and beyond this can be placed into accounts that offer better interest rates. Generally in return for these increased returns there is often a notice period applied to these accounts, or they are for a fixed period of time, and if you need to break the term you will be penalized. This shouldn’t be an issue, as these funds shouldn’t need to be called upon urgently and so can be managed in a more structured way.
There are no guidelines as to how much cash you should have in reserve as it will depend on an individual’s personal circumstances. Someone looking to purchase a property in the next 6 months or changing their car will need a disproportionately higher amount than those just planning their annual vacation.
As with all monies held on deposit in a bank, that money typically works for the bank and not you. When the sums involved grow, it is wise to consider diversifying where the money is held so it works for you and importantly, consider the impact of Sharia’h law should anything happen to you. Please review to my previous article on Wills.
As with most aspects of financial planning, the right emergency fund and cash reserve will depend on your personal circumstances, and your financial advisor can talk through with you to establish your needs and help you plan correctly. Next month I will look at savings and investments.
About Andrew Prince:
Andrew Prince is a Financial Planner at Acuma Independent Financial Advice. With a technical background, Andrew uses his 20 years’ experience as a Financial Planner for the benefit of the client. Holding the Chartered Insurance Institutes Advanced Financial Planning qualifications, Andrew has been helping clients in the Middle East since 2010. Previously, he ran his own FSA-authorized company in the UK specializing in investments, particularly in conjunction with trusts and estate (tax) planning.