If you’ve read any tips or checklists to help your get started with investing, you’ll have seen sorting a cash buffer or emergency fund mentioned.
Having a decent chunk of money readily available in an easy access account is a vital part of any financial plan. But there’s a balance to be had between holding too much cash, which might mean you never start investing, and not holding enough for emergencies or your short term goals, which can leave you financially exposed.
Why an emergency fund matters
An emergency fund is a cash buffer designed to cover essential expenses when something unforeseen happens, such as:
- Job loss or reduced hours
- Urgent home or car repairs
- Unexpected medical or dental costs
- Family emergencies
Without a cash buffer you might have to rely on borrowing or dip into investments at a suboptimal time, such as during a market downturn.
How much should you keep in your emergency pot?
It’s generally said you should have at least three months’ worth of essential expenses in your emergency pot to help you through any financial shocks. Some people suggest up to six months, especially if you have a variable income, or have people who are financially dependent on you. The most important thing is that the cash is easily accessible for you to get your hands on.
Essential expenses generally include rent or mortgage payments, bills, food, transport, insurance and some debt repayments. Luxuries and holidays are not usually included.
If those amounts seem too ambitious, the most important thing you can do is start saving as soon as possible, even if it’s just a small amount of money. Once you’ve built up that emergency pot and paid down any high cost debt, it’s then worth considering investing any excess funds for the long term.
Want to hold more cash?
One technique used in retirement planning is to build a cash flow ladder. If you’ve got a good handle on your spending already, you can map what you need for the next few years. The bottom part of the ladder represents your emergency fund, in instant access cash. This would be something like a deposit or easy access savings account with a bank where the money can be used immediately.
The next rung up could be to fund luxuries, like big holidays in the next couple of years. This is money you don’t need instant access to, but will avoid you having to dip into your investments for in the early years or when markets are more volatile.
Whatever you choose to do with the short- and medium-term cash, make sure you shop around for the best interest rate and account for your needs.
Charlene Young: Senior Pensions and Savings Expert
Charlene Young is AJ Bell’s Senior Pensions and Savings Expert. She joined AJ Bell in 2014 from a wealth management firm where she worked with private clients and small businesses as a financial planner.
Charlene...
