What is a ‘financial safety net’
A financial safety net, or emergency fund, is a stash of emergency savings that can be quickly accessed to cover living expenses, if the worst should happen 🚨
Your emergency fund can be used to cover unexpected costs (such as sudden home repairs or car repairs), or bills which you find yourself unable to pay (due to illness, or in the event that you might lose your job).
There are many benefits to having an emergency fund, but the main aim is to ensure you have money tucked away for a rainy day, and help you weather any financial storms which might come your way!
Why you need a financial safety net
The emergency fund acts as your safety net, allowing you to ride out short-term financial instability with less risk of falling into debt (which can harm your credit score), and without relying on high-interest payday loans.
Creating an emergency fund forms part of your overall saving and budgeting plan, and is just one piece of your personal finance picture 🧩
While everyone can benefit from the peace-of-mind which comes from improving their short-term financial security, you may be asking yourself whether it’s better to start an emergency fund or pay off debts first.
Firstly, let’s clarify that when we talk about clearing debt, in this context we don’t really include student loans. Student loans are actually one of the cheapest ways to borrow money, so it may not make sense to immediately pay-off yours, even if you do have the spare cash 💰
If you’re free of any overdrafts, personal loans and credit card debt, then setting up an emergency fund can help ensure you stay that way!
Is a financial safety net the same as savings
Ultimately, both an emergency fund and ‘savings’ are just a bunch of money.
An emergency fund is simply the term for a particular amount of savings that you’ve ring-fenced for the specific purpose of keeping you afloat, for a set period of time, if things get desperate.
How much do you need for a financial safety net
When planning for your financial future, a key question is that of how much money you should have in your emergency fund 🤔
Working out the right amount for your financial safety net will be dependent on your own circumstances. For instance, your emergency fund calculator should consider whether you have a permanent, salaried job, or if you work freelance. It should also take into account the likely amount of time that it might take you to find alternative work, should you be made unemployed.
The consensus amongst financial experts is that your emergency fund should contain enough money to cover 3–6 months worth of basic living costs.
In this sense you can think of your emergency fund as a ratio rather than a fixed amount. It should contain enough money to cover your rent / mortgage and any essential bills for as many months as you feel appropriate.
How to create a financial safety net
Once you’ve decided to create an emergency fund and calculated your savings goal, then the rest of the process is really just about budgeting.
3 steps to build a financial safety net:
Step.1 Create a budget 📊
Track your average income and the fixed expenses that you know you’ll need to cover over a given month (even if you get paid weekly, it’s easiest to budget over a month as this is how most bills are paid).
Step.2 Prioritise needs, wants and savings 🥇
With an understanding of your earning and spending you can now allocate money for needs, wants, and savings. The amount you save will determine how quickly you can create your emergency fund.
Step.3 Automate your monthly savings 🤖
You can increase your chances of sticking to your budget by making it automatic! Standing orders can’t account for varying amounts, but an app like Plum can automatically arrange additional savings for you...
You can read our earlier guide for more information on how to budget money and savings to build an emergency fund when money is tight.
Where to keep your financial safety net
When starting your emergency fund, you may initially be focused on the challenge of saving money... but before you start to amass a healthy stash you’ll need to decide where you put your emergency fund in the long-term.
It might be tempting to leave the cash sat in your current account or checking account, but the interest rates for these accounts mean they might not be the best solution if you want to protect your savings from the effects of inflation.
One of the prerequisites for an emergency fund is that it should be readily accessible, so a quick withdrawal speed (without incurring fees) will be essential as you consider where you should save your emergency fund ⚡️
For these reasons, an easy access savings account or a Cash ISA might be the most suitable places to store your emergency fund.
Should you invest your financial safety net
If you have a lump sum of money sitting around, it’s natural that you might start to wonder whether you should invest your emergency fund.
While the potentially higher returns available are undeniable, investing your emergency fund also presents a significant drawback.
The limitation with investing your emergency fund is that your money is at risk, because the value of your investments can go down as well as up 🔮
Any investments will tend to fluctuate in value over time, and if you need to access your emergency fund in a hurry (which is precisely its purpose), you could be forced to sell your investments when the value is at a relative low.
Liquidating your investments at such a time means that any losses are consolidated, or locked-in (as opposed to the strategy of continuing to hold the investment in the hope that the price might recover in the future) 🤞
What next after your financial safety net...
If you’ve successfully set up an emergency fund then you’re well on your way to mastering your personal finances.
An emergency fund is one step in your overall money story, and with this in place you can start to think about your next priorities.
If you fancy trying your hand at the stock market then you could consider starting to invest for your future.
Alternatively, if you’re already focused on retirement then a Plum Self Invested Personal Pension lets you invest for the long-term in a tax efficient way.