An emergency fund is one of the basic building blocks for a strong personal finance portfolio. It gives the much-needed strength and support that you can fall back on, should you face any financial emergency. Due to unprecedented job losses that we saw during and after the breakout of the Covid-19 pandemic, the concept of emergency funds has only gained more prominence. In this post, we will cover the basic aspects of an emergency fund.
Table of Contents
What is an emergency fund?
Emergency funds are rainy day funds that form the basic building blocks of any financial planning. An emergency fund is basically money set aside for sailing through any financial exigencies that may arise in the near future. These exigencies may include an unexpected reduction of income, loss of job, sudden hospitalization/medical emergency, etc. The main objective of the emergency fund is to provide a cushion during an emergency quickly and effortlessly.
How much should you set aside for the emergency reserve?
The amount of money that you should set aside depends on your profile. For instance, a young single working person may not require as much emergency fund as required by a working professional with a wife and children. Experts believe an emergency fund to cover your monthly expenses for a period of anywhere between 6-12 months is essential. Include your loan EMIs, household expenses, credit card bills, school fees of your children, etc., in your monthly expenses calculations. These are to be paid essentially irrespective of how much you earn. For example, assume that you are earning ₹70,000 per month and your monthly expenditure is ₹50,000 per month. The ideal emergency fund that you should maintain is anywhere between ₹3 lakhs to ₹6 lakhs.
How to start building your emergency funds?
So, by now you have understood the importance of emergency funds and you want to start saving for the rainy days. But you have a low income or you just earn enough to make ends meet. There are several ways to build your emergency funds and keep them strengthening even after you reach your desired goal.
- Start Small, Be Consistent – Remember the proverb, Drop by drop fills the ocean! Start saving a small portion of your salary/earnings each month in your emergency funds. Try avoiding unnecessary expenses till you reach your desired level of savings. This will build your funds without affecting your regular expenses. This works well even for people who live payslip to payslip.
- Save Your rewards – You get a bonus in your job or have a bumper season in your business. Divert your bonus to emergency funds in place of doing some random or incidental expenses. You can also divert your incidental earnings such as any money received as a gift, any planned expenses getting canceled such as you had to attend a marriage for which you needed to arrange for travel expenses but you are not going anymore (remember that a penny saved is a penny earned) to your emergency funds.
- Look for Opportunities to Save – There are always some expenses that we can easily cut down upon without getting much affected! Say no to all such expenses till you reach your desired level of savings.
There are several other ways of saving like cutting down on buying things that you do not require,being alert of impulsive spending etc. Remember that going small and being consistent is the key.
Where to invest the money that you set aside?
Ok, you have arrived at the amount you needed to set up an emergency fund. It is now time to know where to keep this money. Three important things to keep in mind while investing emergency funds in any instrument are security, accessibility, and liquidity. Keep in mind that an emergency fund is basically meant to sail you through tough financial times. Be clear to differentiate it from your investments. Thus do not keep expectations as to how much this money should fetch you in return. Your focus should be, as said above, on this mantra: security, accessibility, and liquidity of the money that you set aside.
The most probable and easiest instrument of choice would be the savings bank account. The savings bank account is the most easily accessible instrument to park your money. So this is a natural choice for many to set aside money for building an emergency fund.
The second choice could be a fixed deposit in your bank. With the evolution of the internet, it is not difficult to open a fixed deposit account online. This way not only you save money for emergencies but also generate better returns compared to a savings bank account.
The third, more difficult but more rewarding choice could be the Liquid Mutual Funds. I say more difficult because liquid funds do not have a wider reach than bank accounts. More rewarding because on many occasions liquid funds beat the returns of fixed bank deposits. Over the years, the liquid funds too evolved significantly. Some liquid funds now even offer you an ATM card to withdraw your money from the liquid funds at any time you need.
How to invest the money set aside?
We have narrowed down our instruments for parking our emergency reserve. Let’s now see how to proceed with setting aside money. Financial experts believe the 15-15-70 rule is an excellent formula to build your emergency fund. Park 15% of your money in a savings bank account, 15% in a fixed deposit, and the balance 70% in any liquid mutual funds.
When you have reached the necessary amount, review it periodically. Increase the fund whenever your expenses go up.
Overcoming temptation
There might arise situations where you might feel an urge to spend these funds. Here it becomes important to understand whether the situation is a financial exigency before touching these funds. If the answer is no, you need to overcome your temptation to spend even a small portion of these funds.
An emergency fund is a safety net that saves you from borrowing from high-interest debt resources such as credit cards or affecting your future resources such as your provident fund or falling into the cycle of debts at times of financial distress.
Hence, it is important to take care that this money should not be touched upon to meet your regular expenses unless there is a financial emergency.
Conclusion
An emergency fund is a necessity. Many have learned this the hard way during the Covid-19 pandemic. Please don’t consider this as an option. Consider it as a necessity. Without an emergency fund, a personal finance portfolio will never be complete!
With inputs from Puja.