Build up your buffer zone

Continuing her series on investment, Rachel Fixsen suggests emergency funds

Life is full of little surprises. Just when you really rely on it, your washing machine suddenly decides to give up the ghost. Or your car needs hundreds of pounds of repair work if it is to get through its MOT. You can't afford to put off expenditure like this until you've saved up.

Of course you could always borrow the money to pay, by putting it on a credit card or taking out a personal loan or overdraft. But borrowing is expensive. Credit cards charge up to 30 per cent in annual interest after the initial interest-free period, authorised overdrafts cost at least 10 per cent and unauthorised overdrafts cost as much as 41 per cent.

This is why, before you start investing your savings in longer-term instruments, you need a buffer, or emergency fund. This is money you might need for immediate but unforeseen expenses, or holidays. It is money that can be easily accessed and replaced gradually later on.

"Your first priority once you have financial protection in place is to get a cash reserve sorted out," says Fiona Price, managing director of independent financial advisers Fiona Price & Partners, in London. "This should be the equivalent of about three months' expenditure so you've got a buffer."

But don't despair if you cannot manage as much as this. "Three months' expenditure amounts to quite a lot of money for most of us," says Jim Preston of Wesleyan Financial Services. "But having one month's expenditure available would be absolutely essential," he says.

This would be enough to cover you to pay for two or three emergencies, and give you some breathing space. But if you had three months' spending put away, this could be a lifeline if you were made redundant, because it would give you time to make other savings liquid.

You can't afford to take any risks with emergency savings, so don't use this money to buy shares or any other investment where you could lose your capital. And any money reserved to deal with them should be held in an account where it can be withdrawn at short notice.

A building society account is probably best. You could choose a deposit account linked to your current account. This may make it easy to transfer funds swiftly to your current account, so you can use a cheque to pay for that repair you have to make. Postal accounts often tend to pay higher rates of interest than the accounts offered by high street institutions, Ms Price says.

Interest rates vary enormously from account to account. For instance, many savings accounts held with building societies or banks become obsolete after a few years. This means they are no longer offered to new customers. The interest rates on these accounts can lag behind those on the newer accounts being marketed. Some pay less than 2 per cent a year.

Supermarket chains have been offering some of the best savings accounts recently. The rates of interest often compare particularly well for small amounts, with high rates paid on balances of just pounds 1.

Safeway pays 4 per cent on balances of pounds 50, but 7.4 per cent on balances of pounds 2,500. Sainsbury's Bank pays 6.5 per cent gross annual interest on its instant access savings account. Standard Life Bank has a telephone account called Direct Access, which pays 6.96 per cent interest on balances from pounds 1.

Do your own research. Each weekend The Independent and The Independent on Sunday publish tables showing which institutions are giving the best rates of interest for savings accounts.

Beware of choosing a high interest rate at the expense of access. Even if you have an instant access postal account, any withdrawal takes time to be processed.

Does all your emergency fund need to be instantly accessible? If you are using some of it for holidays, you could keep it separately in an account that requires you to give notice before withdrawing cash. Some notice accounts pay higher interest.

Royal Bank of Scotland: 0800 880880; Fiona Price and Partners: 0171 430 0366; Sainsbury's Bank: 0500 405060; Safeway: 0800 995995; Standard Life Bank: 0345 555657; Wesleyan Financial Services: 0800 228855.