Life is full of surprises but you can be better prepared to handle them by building an emergency fund. An emergency fund could be your financial safety net. An emergency fund assures peace of mind.
What is an emergency fund?
The easily withdrawable savings only for unexpected expenses is called an emergency fund. An emergency fund helps you and your family to face financial crises in an emergency like job loss, medical, home and car repair or other unexpected events.
It should be a part of any well-rounded financial plan that ensures your day to day lifestyle is not affected, and you can remain afloat without having to resort to additional debt. It provides you peace of mind.
How big should it be?
The size of the emergency fund depends on several factors such as your income, lifestyle, and number of dependents, existing debt, and so on. Generally your emergency fund would be six times to your monthly expense. For example
If your monthly expense is ₹. 15,000 then your emergency fund should be more than ₹. 90,000.
What to include in emergency fund.
Hence, it is an emergency fund so spending on clothing, subscription to a gym, dining out etc. are must be excluded from it. You should include only essential expenses that are required for day to day routine. It also depends on your lifestyle so think what could be part of your essential expense and what could be not.
How to build an emergency fund?
It is not easy to put a couple of lacs aside but with a step by step plan you can make it with some financial prudence. So take look, here are some tips to make it simple
1. Set a monthly goal:
After deciding the amount of your emergency fund. To make it simple, you can set a monthly amount to deposit for it. It inculcates saving habits and makes the task very easy for you.
2. Trim your expenses:
You can cut out your non-essential expenses. It helps you to achieve your goals quicker, and you can increase your allocation. You have to just prioritize your expenses not that you have to change your lifestyle. For this you can consider things like how frequent you should eat out, watching movies, shopping, etc.
3. Automate transfer:
Having it automated makes sure that you don’t forget to make the deposit for your emergency fund. Most people fall into the habit of saving only what is left over after paying their expenses. So automate the transfer to your emergency fund so that your savings are taken care of on a priority.If possible, Reallocate lumpsum receivables: Have you received a bonus at work, got a tax refund, or an envelope from an aunt on your birthday? Set aside a small amount to enjoy yourself, and allocate the rest to your emergency fund. Adding any windfall gains can really help fast-track your goals.
How to manage an emergency fund?
You have made an emergency fund for life’s little surprises, but where should you keep it? Make sure you keep your emergency fund in a safe spot and that you’re getting a return on your cash reserves. But since this cash needs to be readily accessible in case you need it, you have to choose where to park your emergency fund wisely.
Use a separate account:
By doing this you can keep your emergency fund out of sight, out of mind and this will help you to not getting tempted to spend that money. Ideally, park the money in short term debt funds known as liquid mutual funds.
There are three crucial aspects to look at when deploying an emergency fund: security, accessibility, and liquidity.
The money in this fund is to help you through a tough situation; hence, you cannot deploy it anywhere where there is risk of capital erosion in the short term. Equity/ equity-based mutual funds or any other option with a proportionately high risk should be avoided.
An emergency is sudden event it has no prior warnings. So you have to ensure that the funds are easily accessible so that you can take care of immediate expenses.
This refers to how quickly your investments can be converted to cash. Long-term deposits, bonds, Provident Fund (PF), National Savings Certificate (NSC), etc. do not work as they are either irredeemable before maturity or have an upper limit on withdrawals.
So you have to park your emergency fund where you have the highest liquidity and safety. Ignore the expectation of returns or lowering the tax on this parking activity. Think about RETURNS and TAXATION for your INVESTMENT but not for parking emergency fund. Hence, you can go for strategy given below.
1/3 in your savings account
1/3 in a Bank FDs of a year (online FDs) and another
1/3 in Overnight Funds or Liquid Funds.
Liquid mutual funds vs bank deposits. The entry barrier for liquid funds is low. You don’t need to save a minimum sum to get started in liquid Mutual Fund unlike a fixed deposit. Most banks would need close to 10,000 to get started with an FD. Mutual funds tend to offer higher returns than standard bank deposits, allowing you to at least match inflation if not beat it. Lastly, your bank may levy a premature withdrawal penalty on the deposit, but there is no such cost associated with liquid funds.
To sum up, an emergency fund can make a world of difference in times of a crisis and prepares you against financial setbacks. Remember, like any other financial goal, your need for an emergency fund is going to be dynamic. Which means if any changes in your lifestyle, your emergency funds need to reflect the proportionate change in expenses. Use it as emergency fund, only when you really need it.