What to look out for when building an emergency fund

Kat Cereda: Hello, it's Kat in the Which? studio and today we are tackling a topic that sounds simple on paper but can feel very daunting in reality. And that is building an emergency fund. With grocery bills fluctuating and the energy price cap on the rise, having a financial safety net is more important than ever. But if you're starting from zero, where do you actually begin?

To help us cut through the financial jargon and build a plan that works for real life, I've got two guests with me. We are joined by Matthew Jenkin from Which? Matthew, thank you for being here.

Matthew Jenkin: Nice to be here.

Kat Cereda: And also delighted to say we're joined in the studio by Laura Suter, Director of Personal Finance at AJ Bell.

Laura Suter: Hey there.

Kat Cereda: First though, and this feels very relevant to today's episode, can we talk about some big news that has been talked about over the last few days? Last Thursday, Iran and the US signed a deal aimed at bringing an end to their recent conflict, with international shipping lanes set to reopen. Laura, what could this mean for our finances?

Laura Suter: So I think we've seen a huge impact already and more to come from the war in Iran. And so what we saw obviously was a big impact on oil prices, so they spiked, and you talked about the shipping lane reopening, the huge cost of shipping being stalled or being much more expensive to move through will be passed on into our goods and services. Now we see some of that immediately, and then some of it takes a bit longer to filter through the system. Clearly if these peace talks and if this ceasefire holds, then that shipping lane could reopen, we could see more stabilising of oil prices as more of it moves around the globe, and that could help to temper some of that impact. Now, we've seen some of it already and some of it will continue to filter through because we've had those higher oil prices for longer, higher fuel costs, higher shipping costs. So what we're looking for here is hopefully things returning a bit more to normality. So we're not going to be completely protected from that hit, but hopefully if this holds and there's many ifs in that – that will mean that the impact is more temporary rather than more prolonged.

Kat Cereda: And Matthew, what impact might that have on inflation and interest rates?

Matthew Jenkin: We haven't seen it filter through to the inflation figures yet. So at the moment inflation is steady at 2.0%, but it's probably going to tick up next month when we see the impact from the war, for example on fuel prices, etc. And the same with the base rate, the Bank of England's base rate holding steady, but again, there's so much uncertainty, we don't know what's going to happen. But hopefully as Laura said, this is a temporary glitch. But there's no doubt that it has – you only have to go to the supermarket to see how food prices have been going up, and there's going to be a knock-on effect on everything. It's just we haven't quite felt it yet, I think. But yes, hopefully it's going to be temporary, but we seem to be lurching from crisis to crisis, don't we? So we're just going to have to wait and see.

Kat Cereda: Yes, as you said, so despite this recent news, food costs are still rising and energy bills are much higher than they were even just a few years ago. So the idea of an emergency fund right now makes complete sense, which is why we're talking about it today. But for a listener who has absolutely no savings right now – relatable – how should they think about calculating a realistic safety net goal without getting overwhelmed by the numbers?

Laura Suter: So I think that that's often the case, is we hear a bit about emergency funds and you should have this stash of cash away for if you have an emergency like your boiler breaks or you lose your job, or prices suddenly go up or your rent goes up. And then I think sometimes people look at the figures of what they should be ideally having in that pot, and it terrifies them and they think that's just going to be impossible. And then that just deters them and there's a bit of a head-in-sand mentality and they think, I'll just go to the pub instead, rather than focusing on this savings plan. So I think the key thing is if you're in that camp and it feels like too high a hurdle, then just start small. And I think there's a real benefit from working out even a small amount that you can put away each month, putting it in a separate account so it's ring-fenced and it's out of sight, out of mind, and then building on that from there. And actually lots of people will find that after a few months of doing that, they've then got a bit of money in that pot and that's quite motivational and they think, oh this actually feels good and I feel quite secure having this bit of money to fall back on, can I maximise it? Where could I budget or cut back from so that I could save a bit more in this? And so I think it has a positive mentality to it and you're building that great savings habit. Because if we look at some of the parameters, some of the guidelines are you should have between three and six months' worth of essential expenses. So not income, but your essential things that you can't live without. So your rent or your mortgage, your food costs, things like that. And actually once you add that up, that can be a lot of money. And so I think that can deter people. So I really think if that feels too out of reach, then just start small and get into that savings habit and start where you can and build from there.

Matthew Jenkin: Yes, absolutely. I agree and things like instant access accounts are really helpful for emergency savings. There are some really great rates out there at the moment as well. You can get up to 5% at the moment. Regular savers are also brilliant for people who just want to put away small amounts of money a month. Usually it's about £200, £250 maximum. Santander have just launched a new one which has an 8% rate, which is brilliant, so they're the market leaders right now. So there are some really great options out there. There are lots of accounts where you can just put small amounts in and just do it slowly and build that savings habit. That's what's important.

Kat Cereda: Sure. So we'll touch more on the different rates in a moment, but before we move on to that, at the moment it kind of sounds as if we're talking potentially younger people who haven't yet started their pot. But does the advice differ compared to if you're retired, for example, versus if you're still working?

Laura Suter: So I think you should still be aiming for that cash savings pot that you can fall back on in case of an emergency. But for retired people it's obviously arguably even trickier because they don't necessarily have that regular big income coming in that they can save from. So for them it's looking at what pension income do they have coming in, and what other pots of savings or investments do they have. And then if they've got existing savings and investments, it's ring-fencing, either physically by putting it in a different account, or mentally or on a spreadsheet, ring-fencing a pot of money that they're going to use as their emergency fund if they need to dip into it. For those that don't and they're just living on their pension income, it's working out how to save a bit of money from that in the same way as if you were working. But it is trickier for those retired people, they can't just decide to move jobs to get a pay rise or apply for a promotion to boost their income so that they can boost their savings. So there is more of a case of mapping out what their spending needs are, where they can potentially save money and building that pot of savings as well.

Kat Cereda: So we've already touched on rates a bit, but just to go back to that. So if you search online for best interest rates, regular saver accounts typically immediately pop up with some very eye-catching offers. Around 7%, I believe you said one was around 8% as well. And I know you've spoken briefly, Matthew, about how these accounts can be a bit of a double-edged sword because they often come with a lot of catches. So can you talk me through what these strings-attached parts are?

Matthew Jenkin: Sure, so for example, the one I just mentioned, Santander's 8% account, you need to have a current account in order to open the savings account. That's actually not as big a deal as you might think because the account is open to new customers as well as existing. So it's as simple as opening a current account.

Kat Cereda: You haven't got to put much money in there or anything?

Matthew Jenkin: No, you'll have to – there are rules for opening a current account. Usually you have to have so many direct debits, so you need to have a look at what their terms and conditions state. But once you've opened that account, then you are free to get started with the regular saver and it's open to all their current account customers. They've got several different products on the market. And this regular saver that they currently offer has very low minimum deposits, only £1, and it's £200 a month maximum. And after about 12 months, I think from just off the top of my head, it's just over £2,500 that you'd earn including the interest.

Kat Cereda: So does that – sorry to interrupt – so it's not just opening up a current account, from what I'm gauging from what you're saying, is that you sometimes have to switch whatever current account you use at the moment.

Matthew Jenkin: Well you don't have to switch. But if you do, they do have a switching offer. And the switching offer I think is £180. Off the top of my head! But there is a switching offer at the moment. So it's not always required for you to switch. No, you can just open, you can have as many current accounts as you want. But if you want to switch, they do have a switching offer. So you could, that's free money. And other accounts, a lot of them do have catches, for example, there might be restrictions on the number of withdrawals you can make. So you should definitely pay attention to the small print.

Kat Cereda: And so when deciding if chasing that high rate is actually worth the hassle, what advice would you give to a beginner when they're seeing these amazing offers? How do they know if it's worth their time?

Laura Suter: I think there's probably a few things to consider. So I think if you're using it for your emergency savings pot, and as Matthew says, it's got restrictions on how much you can withdraw, then it's probably not the ideal place for that because that emergency pot is money that you need to be able to access immediately if something happens. But if you've already got a bit of money or there aren't withdrawal limits on that particular regular savings account that you're looking at, then it can be a good option. But you will maximise your interest that you're getting on it. But it's important to acknowledge what kind of saver you are. Are you someone who is going to diligently pay that money in each month or set up a direct debit so that money goes out? Are you realistically going to be able to afford that money going in each month? And are you going to remember to switch after six months or a year when that bonus rate ends? Because what a lot of banks are relying on is they offer you this juicy rate to get you in, that lasts for six months, 12 months, and then after that point, your rate will plummet or it might have a bonus rate on it that goes to zero. And then your money is sitting there earning far less than it could be if it was just in a standard savings account. So I think it's important to acknowledge, are you the type of person that's going to set a reminder for that and is going to actively then switch to another regular savings account or to just a standard savings account? Or are you, and this is totally fine if this is you, are you one of those people that's going to come back to that account in five years' time and think, oh I've forgotten my login and I've forgotten where that money is sitting, and it's now earning 0%? I think it's important to acknowledge how active you want to be, how much spare time and headspace you want to put into it. Because if not, then you're probably better going with a standard savings account. Although often they do still have some bonus rates and some 12-month offers. It might be better to go for a more standard account.

Kat Cereda: Do some self-reflection before you make the decision!

Laura Suter: Some deep thinking before you start this emergency savings pot!

Matthew Jenkin: I was going to add because you mentioned that was another restriction that's very common, or not so much a restriction but a catch, is that when we're talking about these headline rates, often they do include a bonus rate. And that usually expires after 12 months and it can be quite a big reduction after that 12-month period. So you really got to keep an eye on that if getting the best returns are really important to you.

Kat Cereda: Is another restriction with these types of accounts that you have to put in a certain amount, a minimal certain amount a month? Because what if you are someone who can only put a little bit away, potentially one month is more tough than usual and you're not able to put anything? Can you get penalised for that?

Laura Suter: Yes, so it's important another reason to look at the terms and conditions. So some of them will have a really low minimum, others might have a higher minimum, so it's important to pick the right account for you depending on how much you know that you can put away each month. Another reason why it's important to weigh up whether it's right for you.

Matthew Jenkin: And to add to that, sometimes there are some accounts, for example, Kahoot, who will only pay interest up to a certain amount. So for example with Kahoot it's £3,000. If you put in more than £3,000, anything over that amount won't earn any interest at all. But if we're talking about only saving small amounts, that might not matter to you. But if you've got more cash to put away, then it suddenly becomes quite important.

Kat Cereda: My last question on this part before we move on, although I feel I know what you're both going to say. But you have discussed about how these magical rates can finish after a fixed amount of time. What is the biggest mistake people can make when that term ends?

Laura Suter: So I think it is just leaving that money sitting there and not actively switching it. I think what you need to do is set a reminder in your phone for that date when that bonus rate ends or when that offer rate ends. And then at that point really focus on just switching that money to the next best account at that point. But too often I think people haven't really engaged with the account maybe for a year, if they set up a direct debit that just pays in monthly. Maybe try to go and find their login details and they've forgotten their password and then it just becomes a thing that's on your to-do list that you don't get round to doing. So I often put it in my calendar if I do a food delivery service, free trial month. One month is a lot easier to remember than 12 months, so yes, I think it's getting into that mentality, isn't it?

Matthew Jenkin: Yes, I'd say the same. And the only exceptions where you might get a reminder are fixed-rate accounts where they'll usually send you an email a couple of weeks before the account matures. And they'll say look your account's going to come to an end, what do you want to do with it? And the danger is with those accounts that if you really don't switch, sometimes it'll either get rolled over into another fixed-rate account possibly paying not the market leading rate, or it will be moved into one of their holding accounts that could pay pretty bad interest. In my case, it's going to go to a 1% interest account where it's just, if I do nothing it's going to sit there earning a pretty abysmal rate. So you do need to pay attention and set reminders, especially if you haven't engaged with it or you haven't touched it for a good amount of time. But I would say if you really don't think you're going to touch the account, you might be happy then to put up with some more restrictions. For example, as we mentioned, some do limit the amount of withdrawals you make, and those sort of limited-withdrawal accounts pay higher interest. So I think you do have to weigh up how you're going to use that money and how often you're going to need it.

Kat Cereda: So it literally pays to pay attention essentially.

Matthew Jenkin: Yes.

Kat Cereda: Sticking with the theme of someone on a tighter budget, so you can tell it's me who wrote this script. If someone can only manage to put away a small amount of money each month, say that's only 20, 50, or 100 pounds a month, are they better off putting that money into a cash Isa or a standard savings account? Can you break down for me how the tax benefits stack up when you are dealing with these smaller monthly contributions?

Laura Suter: Yes, so a cash Isa, all your money within there will be protected from tax. So you won't have to pay any tax on the interest that you earn on that account. Now, I think there's a few things you need to factor in. If you're saving a small amount of money and you're not a higher or additional rate taxpayer, so if you're a basic rate taxpayer paying 20% income tax, then you might look at that and think well my savings are never going to earn enough for me to pay tax on that interest. Therefore, I could just go for any account, a non-Isa account and just hunt out the best interest rate possible. And I think that's a perfectly sensible route to take because the likelihood is that that pot of money, at least in the short term isn't necessarily going to hit those limits. So I should probably go back a step. You get what's called a personal savings allowance. So this is the amount that you can earn tax-free from your savings interest. If you're a basic rate taxpayer it's £1,000 a year, so that's £1,000 of interest you can earn on your savings before you pay tax on it. For a higher rate taxpayer it's £500 a year, and for an additional rate taxpayer you get none of that tax perk, so all of your interest on your savings would be taxed at 45%. So if you're in that basic rate group and you're protected by that £1,000 savings interest, then the likelihood is you're not going to hit that in the short term. And if you did come to hit that, then you've got a £20,000 Isa allowance where you could easily move that savings pot into a cash Isa in one year and protect it from tax. There's a few caveats to that. I would say if you're in the likelihood of moving up into that higher rate tax band anytime soon, that means that that tax-free amount that you can earn from your savings interest will be halved from £1,000 down to £500, and that could impact you and that could mean that you start paying tax on your savings. Equally if you're likely to move into that additional rate band, I think we generally would assume that people who are additional rate taxpayers, they're quite high earners, maybe they're saving more, but that might not necessarily be the case. If you're a sole earner in a large family and you've got a lot of costs going out, that might not be the case. So if you're going to become an additional rate taxpayer, then that cash Isa is really the better place for your savings because you're not going to be paying any tax on that interest. There's also the big uncertainty of what future governments are going to do with Isas and Isa limits. We've seen some tinkering with cash Isas that's going to come into effect soon. And whilst at the moment you might be sitting there thinking well I've got a £20,000 Isa allowance and if my savings get too big or I start paying tax on it, I can easily move that into an Isa in one year, we don't know what future governments are going to do with Isas. That allowance could be cut, they could make changes to it that could then mean that you can't move all of your money into a cash Isa in one year and then you're stuck paying tax on it. So I think it's important to think about the future both from what the government might do, but also from your future earnings and whether you're likely to pay tax on that money. I think it's also good to think about what the interest rates on offer are. So previously we used to see that cash Isa savings accounts had a lower interest rate than standard savings accounts. That's actually not really the case anymore and actually in some instances and some months, cash Isas have had the higher rate. So it's important to weigh that up. If you're not paying a penalty for using that cash Isa and you're actually getting a better interest rate for it, then it's a why wouldn't you?

Kat Cereda: Is there a specific time of year when cash Isa rates become extra competitive?

Matthew Jenkin: Yes, we usually see rates go up and the best deals are often at the beginning of the tax year and the end of the tax year. And that's because your tax-free allowance currently at £20,000 renews every year. So if you haven't maxed out that allowance by the end of the year, there's a bit of a rush among savers to pour money into a cash Isa. And providers are therefore keen to attract those savers and so they compete over the rates that they offer. And exactly the same reason at the beginning of the tax year, they want to attract new savers or people who are looking to again max out early or get the best deal. So that's usually about April, May. Sometimes it drags on longer, and at the moment rates are ticking up across the market, so you can still get really good deals now. And there's even more incentive for a lot of savers this year who are worried about their tax-free allowance because, as Laura mentioned, the government is going to cut the tax-free allowance on cash Isas from £20,000 down to £12,000 for under 65s, unless they put £8,000 in a stocks and shares Isa. So if cash is really important to you, this is your last year as far as we know. As far as we know for now, this is your last year that you'll be able to save the full £20,000 in cash.

Laura Suter: Yes, so there's definitely a seasonality to it, 100%. And then I think it's just what's happening in the wider interest rate market. And so if you're looking at an environment where the Bank of England is cutting interest rates, then you are likely obviously clearly going to see those savings rates plummet too, and they react very quickly if not slightly ahead of what the Bank of England is doing. Equally if we're in a rate-rising environment, then sometimes it's worth holding out for a higher rate. It's notoriously difficult to predict what the Bank of England is going to do. Even the experts fail to do it accurately all the time. So it definitely shouldn't be something where you're trying to second guess that. But we do also see just random spikes of competition between providers. So it could be that a new provider comes to the market and is launching a really juicy rate because they want to draw in more customers. And then that then sparks more competition among providers. So sometimes you can just see these random spikes where suddenly there's really good rates on offer and it's not linked to tax year end and it's not linked to interest rates, but it's just something that's happening within the savings market. So it's always a good idea to keep an eye on those best buy tables and see whether it's worth switching.

Kat Cereda: Yes, make sure you keep an eye on Which? website to make sure you're getting the best deal. A lot of people naturally stick with the big high-street banks that they've used for years, even though the data shows that they typically pay lower interest on instant access accounts compared to the smaller challenger banks. For someone who isn't a financial expert, what are the psychological barriers to switching would you say? And how would you recommend they overcome that fear of moving their hard-earned cash to an unfamiliar app-only bank?

Laura Suter: Yes, I think it's difficult because I think trust is such a huge issue within the financial sector, and we hear stories every day of people being scammed or defrauded. And so I think naturally that makes people quite cautious of these new names that come out because if they're new, we've not really heard of them, they're not household names. And so that means that people tend to gravitate towards the big high-street banks that have that brand recognition. They have that trust because they've been around for a long time, and it makes them more cautious about those new providers. So that's a perfectly normal human instinct. However, you're often leaving a lot of your own money on the table if you're opting for a high-street bank that's perhaps offering a much lower interest rate than some of these newcomers. So there's some good due diligence that you can do to check out if a provider is legit, if they're well financially backed. Going to trusted sources like Which? for example, and looking at whether they've been rated by Which?, looking at whether they're FCA registered, looking at whether they're appearing on reputable websites, is a really good indication of whether they're good. But I get it, you're trusting your money with another provider, and sometimes for people the difference in the rate that they could get isn't worth that risk to them. But the reality is that these new banks, they're hungry for people's savings, they don't have the overhead costs of having this big branch network like the high-street banks, and they know that they've got to get through that trust barrier and break through in another way. So they're offering these really high rates. And so it shouldn't be an option that's just dismissed immediately. You should definitely do some digging and see if you can get comfortable with them because you can earn so much more with them often.

Kat Cereda: To clarify for anyone listening, your money is just as safe in a newer digital bank as it is with a traditional bank?

Matthew Jenkin: Well you'd need to check. You need to do your research. If you're unfamiliar with a provider, then it makes sense to do some of the checks. You need to check whether it's FSCS protected. And that protects your money if the bank should go bust. So you need to check that. And some of these newer banks or smaller banks, the ones I shouldn't call them banks actually because some of them don't have banking licences. But that doesn't mean that your money isn't protected. But it does mean that you should definitely check, go on their website, do a bit of your own research. And there should be a section where it talks about what protection your money has. And what you are looking for is FSCS protected. And that protects up to £120,000.

Kat Cereda: So if someone's done their due diligence and they decide that they do want to switch, what is the first step that they should do to make it painless and easy?

Matthew Jenkin: Switching savings accounts, it's not quite as straightforward as switching current accounts which has a dedicated service to do that. But it's also not that difficult. It tends to be relatively straightforward. You just need to close your account and move the money to your nominated current account, and then you can just open a new savings account and deposit the money in there. So it's down to you to do the legwork, but it's less streamlined essentially. It's less streamlined but it's not that difficult at the same time.

Laura Suter: And I think the only other caveat is if you are in a cash Isa, is to make sure that you do an Isa transfer rather than removing the money from that cash Isa back into your current account, for example, and then back out to a new cash Isa. Because you then potentially lose some of your Isa allowance, whereas if you transfer it, that money is preserved and it's not affecting your current year's Isa allowance. So for cash Isas, just make sure you go through that transfer process. But yes, as Matthew says, it's not... we're all used to paying friends money, making bank transfers in different ways. And so it's pretty quick. And particularly with these app-only savings providers, it's so quick to open accounts now. I opened one the other week and it took me five minutes to open a savings account. So once you've done that research and you've picked the account, it's very easy to do that and then transfer in the money.

Matthew Jenkin: And some of them even now, I opened an instant access with Spring, and they even link your current account within the app. So you can transfer money even quicker between your current account and savings account. They're making it easy for you. Especially the digital banks and the app-only ones, yes.

Kat Cereda: Great, well thank you Matthew and Laura for your time.

Laura Suter: Thanks very much.

Matthew Jenkin: Thanks for having me.

Kat Cereda: That brings to an end another podcast from Which? There's loads more for you to read about everything we discussed today; just head to the episode description for more useful everyday advice. There you'll also find an exclusive offer for podcast listeners like you to become a Which? member for 50% off the usual price, giving you access to our product reviews, our app, one-to-one personalised buying advice, and every issue of Which? magazine across the year. Plus, your membership helps us to make life simpler, fairer, and safer for everyone. If you'd like to know when we release a new episode, then make sure you press subscribe wherever you're listening. That way, you can be one of the first to listen. And for any questions, comments, or anything in between, follow us on social media at WhichUK or email us, podcast@which.co.uk. Goodbye!