This is the stage we need to make sure that we have enough money for those small inevitable emergencies that happen in life this could be anything from an unexpected car breakdown to some sort of medical problem that you need to pay for. Really this need to be £500-£1000 it may take several months to build up this small emergency fund but it will be one of the keys that will stop you from having to rely on debt again. The whole idea of this stage is that it stops you from having to get in debt ever again.
This fund should be kept in some sort of quick access savings account. In the UK I would recommend putting this money in an instant access high paying savings account in the past I would have recommended an ISA as these used to provide the best interest rates while also removing the need to pay tax on any interest earned. Recently the UK government has allowed some savings to be earned without paying tax on the interest earned so you really just need to find a high paying savings account with the instant access. If you live in another country you should be looking for a savings account that allows instant access with no penalties or loss of interest.
This money should not be used for investing as you will need to have access to it and you do not want to take the risk of taking a loss when the investment is down just because you need to use the money for an emergency.
Like the title says as this is an emergency fund it should not be used for things that can be predicted such as servicing your car or an paying for an MOT or general maintenance on your house as these should have been included in your budget. Christmas presents and birthday presents should also not be purchased from your emergency fund.
You really want to build up this emergency fund as soon as possible so that you do not need to go into debt again.
Once you have a full emergency fund you can move onto the next stage, but if at any point you have an emergency and you need to spend some of your emergency fund then you should come back to this stage once the emergency has past so that you can build your emergency fund back up to its original size of £500-£1000.
One other thing to consider is if you see any emergency situation coming a few months or even weeks in advance then you should build up your emergency fund as much as possible and hoard as much cash as possible. For example if you know you are going to lose your job or be made redundant then you should increase the size of your emergency fund to be as large as possible. Once the emergency has passed and you have got a new job or you did not lose your job you can then reduce your emergency fund back to the £500-£1000 and use any money you managed to save to pay off your debts.
It is really important that you have this money in place as it allows you to move forward and not worry about any problems that may occur.
The Normal Person