This blog will walk you through everything you need to know about building an emergency fund—from understanding the importance of financial liquidity to exploring why an emergency fund is essential and considering alternatives. Building an emergency fund is a simple process that can supercharge your wealth journey.
Please note that any information supplied on this website is for entertainment purposes only and should not be taken as financial advice. Any reader should do their own research and/or consult with a qualified financial advisor.
What is an Emergency Fund?
Emergency funds do exactly what they say on the tin – they ensure someone can cover their expected and unexpected expenses if their income stream is cut off or insufficient. They are an essential part of any well-thought-out budget.
Life generally brings with it a lot of unwelcome financial expenses. For instance, only recently I had to get one of my alloys refinished.
I didn’t know this £100 expense was coming my way, but it was important to get it sorted out. We don’t know when these unexpected expenses will come around, or how much they will cost. Our only certainty is that they are coming our way at some point.
Aside from this sudden emergency expense, there are other reasons why we should have an emergency fund. For instance, if you lose your main source of income, it becomes necessary to have funds that tie you over until you find a new job or until cash flow is restored.
In the UK and the US, many people live one catastrophe away from financial ruin.
In fact, half of Brits have no money set aside for emergencies, and of those with an emergency fund, only a third have enough to cover 1 month of expenses.
In the US, 2 in 5 people cannot afford an emergency over $400.
Just to explain the seven key characteristics of an emergency fund, I’ll show below what these are as stated in my blog, 7 Ways to Budget like a Boss.
The 7 Key Characteristics of an Emergency Fund are:
- Easy Accessibility (liquidity)—keeping it in a liquid account for quick access
- Separation from regular savings to prevent non-emergency use
- Three to six months’ worth of living expenses
- Kept in stable investments or cash (preferably cash or treasury bonds)
- Used only for genuine emergencies
- Regularly replenished
- Adjustable to accommodate life changes
A Starter Emergency Fund
Building a starter emergency fund of $1,000 or £1,000 is an essential first step toward financial stability.
Dave Ramsey, the famous personal finance guru, recommends beginning with a $1,000 emergency fund to kickstart financial security.
As he says, “Save $1,000 as fast as you can. Your emergency fund is your first line of defence.” This fund covers unexpected expenses, helping you avoid debt while building financial momentum.
This initial amount is enough to cover most small emergencies, such as car repairs, medical bills, or urgent home repairs.
By having this fund in place, you can avoid the need to rely on credit cards or loans, which often come with high interest rates that can lead to a cycle of debt.
My least favourite type of credit is the infamous payday loan, with sky-high interest rates. People tend to borrow small amounts, but these small amounts can easily compound at frightening rates.
In fact, a survey conducted in 2013 by TNS BMRB established that the average payday loan amount is £239.
The average APR for a payday loan is The average APR for a payday loan is around 1250%. In my view, this is practically criminal and preys on the disadvantaged.
One Month of Expenses
Once you’ve established a starter emergency fund, the next goal is to save enough to cover one month’s worth of expenses.
This gives you a bit more breathing room and can help you manage larger, unexpected costs or short-term income disruptions without immediately dipping into credit or other savings.
Three to Six Months of Expenses
Ultimately, your goal should be to build an emergency fund that can cover three to six months of living expenses.
This amount offers substantial protection against longer-term financial disruptions, such as job loss, medical emergencies, or significant home repairs.
With this level of savings, you can confidently navigate challenging times without the immediate pressure to make drastic financial decisions.
I believe that if you have mortgages to pay, children, work as a contractor, work on commission or own your own business, it is critical to have at least a 3-month emergency fund, but preferably six.
If you’re the type to value your piece of mind, then it could even be worthwhile saving one year of expenses, but even I don’t do that.
Alternatives to Traditional Emergency Funds
While a traditional emergency fund in a savings account is ideal for most people, there are some alternative options worth considering.
Alternative Options for an Emergency Fund
- Investment Accounts: Some individuals choose to use investment accounts for their emergency savings, hoping to earn higher returns. However, these accounts are subject to market volatility, which means your funds could lose value just when you need them most.
- Lines of Credit: A line of credit can provide quick access to funds in an emergency, but relying on this option can lead to accumulating debt, especially if you’re unable to repay the borrowed amount quickly.
- Income Protection Insurance – You might have taken out some income protection insurance before when you were applying for a mortgage or if you have a family. I think this can make a lot of sense, but an emergency fund is more accessible quickly and efficiently, so insurance, whilst effective, cannot replace an emergency fund in terms of providing liquidity.
- Retirement Savings: Tapping into retirement savings should be a last resort. While it may seem tempting, early withdrawals often come with penalties and tax consequences that can severely impact your long-term financial goals.
- Credit Cards: Using a credit card for emergencies is a common fallback. Paul Gabriel of Everything Money even recommends this approach as an alternative to a traditional emergency fund. However, this strategy carries significant risks, especially if you’re unable to pay off the balance quickly. High interest rates can lead to mounting debt, which defeats the purpose of financial security. Credit cards are, however, easy to access so they fulfil the liquidity requirements for an emergency funds.
Balancing Risk and Return
Keeping too much cash in an emergency fund indeed means missing out on potential investment gains.
Every time you replenish your emergency fund, you’re diverting money that could otherwise be compounding.
However, personal finance isn’t solely about maximising returns and mathematics — it’s also about managing risk and maintaining peace of mind.
Final Thoughts
Ultimately, the right choice depends on your financial situation and risk tolerance. While alternative options may offer higher returns or quick access to funds, they often come with significant risks.
A traditional emergency fund may not yield high returns, but it offers stability and security when you need it most.
Conclusion
Starting and building an emergency fund is a crucial step in achieving financial stability and peace of mind.
Whether it’s covering small, unexpected expenses or safeguarding against larger financial shocks, having an emergency fund ensures you’re prepared for whatever life throws your way.
By taking the time to build and maintain this fund, you can protect yourself from financial stress and stay on track toward your long-term financial goals.
