The Covid-19 pandemic has shown us how crucial it is to be prepared for emergencies. Many people incurred huge medical debt; some lost their jobs; others had their salaries reduced. Businesses shut shop. Many have faced economic hardships due to the pandemic. This is why it is so important to have an emergency fund.
What is an emergency fund?
As the term suggests an emergency fund is a fund where you save for emergencies. It tides you over in times of unexpected expenses. The fund has to be able to meet financial shortages in an emergency.
What expenses should an emergency fund cover?
Your emergency fund should cover obligatory expenses such as your rent, maintenance bills, utility bills, monthly loan payments, education fees, insurance premiums, and food and medical bills.
Whatever your indispensable expenses may be, your emergency fund should cover them; this could include paying gym fees or domestic help fees.
Emergency planning for an emergency fund
The fastest way to plan for an emergency fund is if you have an existing record of all your expenses for the past few months. If you don’t have that, then you need to start from scratch. Here is how to do it.
- Step 1:
Record your monthly expenses for three to six months to get an average of your monthly expenses.
- Step 2:
Classify each expense as dispensable or indispensable. Your rent will be an indispensable expense, but your Netflix subscription may not be. Again, you decide the classification.
- Step 3:
Once you have your average monthly spending, draw up an emergency fund that will cover all indispensable expenses for three to six months. An emergency fund that covers you for 9 months is even better.
So, if your monthly indispensable expenses come up to Rs 45,000, your emergency fund should hold a minimum of Rs 1.35 lakh (covering three months). For six months, this amount increases to Rs 2.7 lakh or Rs 4 lakh for nine months’ coverage.
How to build your emergency fund?
- Set a goal:
Set a date for achieving your goal after three, six, nine, or 12 months. The target date may hinge on your financial situation. The sooner you start saving for it, the better.
- Decide on the strategy:
When setting your target date, account for all current assets that can be channelled into the emergency fund. Things like fixed deposits, upcoming salary bonuses, insurance policies that are about to mature, and the like. So, get the strategy in place of how you plan to create your emergency fund.
Remember, a credit card is NOT your emergency fund!
- Shortfall management:
After accounting for the assets that can be used for your fund, you could still have a shortfall amount. To overcome this shortfall, divide the amount into monthly instalments.
Suppose you have a shortfall of Rs 60,000 and a target date of three months hence. You can save Rs 20,000 per month to achieve this shortfall amount within that time.
- Mentally account for your emergency corpus:
Use a separate bank account to save for your emergency fund. This will prevent you from accidentally withdrawing from your emergency fund.
- Save up till Emergency Corpus is achieved:
Ensure that all extra income inflows and cash gets deposited into the emergency fund bank account, which will help reach your goal faster.
Try not to start another investment or commitment before the emergency corpus is achieved.
Where to save your emergency fund?
- Cash:
Most people in the older generations kept their emergency corpus as “cash” at home. This was before the digitalisation happened. However now, cash could be used for emergencies but safety may be an issue. Moreover, there is no return on capital.
- Bank account:
Park your money in a savings account with a sweep-in facility that channels money over a certain limit into a fixed deposit (FD). There is no withdrawal limit but you may have to pay certain penalties. Your corpus will earn savings account interest and FD interest.
- Short-term FDs:
FDs earn interest but are subject to penalties and tax. Understand the terms and conditions before parking your emergency money in one.
- Liquid mutual funds:
These offer better returns than all other options. They also have better tax benefits and fewer penalties compared to FDs.
- Diversify:
You can split the emergency fund in a ratio of 20:20:60 among savings account with a sweep-in facility, longer tenure bank fixed deposit, and liquid funds wherein:- 20% of the corpus in a savings account with sweep-in FD facility could be utilised first for short-term emergencies. Encashing this is the easiest and can be done through the netbanking or mobile application itself instantly.
- Another 20% of the corpus could be in a longer duration bank or post office FD, which would be liquidated within a few hours.
- The remaining 60% could be kept in a liquid mutual fund.
Ideally you should invest your emergency corpus in a liquid mutual fund instead of leaving it in a savings bank account or cash at home, as you would get better returns, better tax efficiency and have a lesser chance of spending it for ad-hoc expenses.
- 20% of the corpus in a savings account with sweep-in FD facility could be utilised first for short-term emergencies. Encashing this is the easiest and can be done through the netbanking or mobile application itself instantly.
Summing up:
You never realise the importance of an emergency fund until you need one. Review your expenses and your fund every year to ensure it does not fall short. Account for any lifestyle, life, and family changes. Never underestimate the importance of an emergency fund; it offers peace of mind in times of uncertainty.