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Emergencies can happen to anyone, anytime, and having an emergency fund can be a lifesaver. Whether it’s unexpected medical expenses, a sudden job loss, or a significant home repair, having the necessary funds readily available can help you tackle these challenges with ease.
To ensure you’re financially prepared for such unforeseen situations, it’s important to understand the concept of an emergency fund and how to build one. Our article aims to provide clarity on the meaning of an emergency fund and its importance in your financial planning.
In this article, We will delve into the significance of emergency money and how to create an emergency fund. So let’s get started and learn how to secure your financial future with an emergency fund.
What Is An Emergency Fund?
An emergency fund is a reserve of funds that you set aside for unexpected financial emergencies. It is an essential part of any sound financial plan, as it provides a buffer to help you weather unexpected expenses without resorting to debt or other forms of borrowing. Emergency funds are typically kept in a savings account or a money market account, where they are easily accessible in case of emergency.
Experts recommend that you have at least three to six months’ worth of living expenses saved in your emergency fund. The exact amount you need will depend on your personal circumstances, such as your job stability, income level, and number of dependents. In addition, it’s important to regularly review and update your emergency fund as your circumstances change.
Why Do I Need An Emergency Fund?
Without an emergency fund to fall back on, even a minor financial shock can have a significant and long-lasting impact on someone’s financial condition. Researchers have found that people who face difficulty recovering from a financial shock usually have a lesser reserve of emergency funds.
These people generally tend to rely on credit cards or secured/unsecured loans, which mostly leads to debt that is even harder to pay off. They might also try to balance things financially by pulling funds from other savings, such as retirement funds.
Emergency funds help one stay afloat in times of financial crisis without having to depend on high-interest loans or credit cards. Thus, building an emergency fund that can function as a rainy-day fund is extremely necessary.
How Much Do I Need In It?
The amount one must stash away as an emergency fund depends on several factors, including income, existing debt, number of dependents, etc. However, the general rule of thumb is to keep aside around 3-6 months’ worth of essential expenses. People having unstable jobs are advised to set aside 6-12 months’ salary as an emergency fund.
Hence, the first thing one needs to do is to determine what constitutes their expenditure. The expenditure usually consists of “essential expenditure” and what part of income is used to meet those expenses. The “essential expenses” include the funds that are required for day-to-day functioning. Essential expenses can be further subdivided into fixed expenses and variable expenses.
- Fixed expenses include maintenance/rent, insurance premiums, mortgage payments, other loans(education/car), salary for staff (driver/house help), school fees, etc.
- Variable expenses include medicines, groceries, electricity, phone bills, internet, travel expenses, and other incidentals.
Frugality is the key to saving up for emergencies, goes without saying. Hence, dining out, spending on clothes, a gym subscription, etc., are generally left out of the ambit of emergency money.
To put it in numbers, say, for example, if Mr. Agarwal’s living expenses amount to Rs. 30,000. Then his emergency fund should be between Rs. 90 thousand and Rs. 1.8 lakhs. However, this amount depends solely on Mr. Agarwal’s family situation.
Thus, The emergency fund of a person who is the sole earning member of a family will look different from that of a bachelor.
How Do I Build It?
Saving is doubtlessly a good habit. However, setting aside money for emergency funds must be planned, regular, and disciplined. There is a wide range of strategies to save money for emergencies. One can use one or more strategies per your financial condition to build up your emergency fund.
1. Set A Goal
A definite savings goal plan is a time-tested method of saving up money. A plan helps one stay motivated and enthusiastic. While making a plan, one needs to consider their monthly income and expenses to clarify how much one can save. Then, one can fix a reasonable goal using a savings planning tool found in abundance online.
Using such a tool, one will be able to calculate the possible amount one needs to set aside each month to attain your goal. It also helps to identify the number of months it would take you to reach the goal. The next thing that needs to be done is to curtail unnecessary expenses. Any excess amount in your budget should be strictly directed toward emergency money.
2. Create A System For Making Consistent Contributions Of Emergency Fund
To be able to contribute towards the emergency fund consistently, one needs to be a strict disciplinarian. However, if one is not so, then creating an automatic savings plan is the best and easiest method to make your savings consistent.
An automatic savings plan is indeed quite simple. One must schedule a recurring deposit from either checking account into the linked savings account. The frequency of deposits will depend solely on how often money is credited into the checking account. It can also vary as per the user’s personal preferences.
Setting up an automatic savings plan removes the burden of manually transferring money. Moreover, when savings are automatic, one is less likely to spend the excess money on unnecessary purchases. In fact, in no time, savings will become a habit, and one can effortlessly grow their emergency fund.
3. Regularly Monitor Your Emergency Fund Progress
Regularly monitoring one’s savings is indispensable to the entire savings process. One needs to devise ways to keep them self motivated. It can either be in the form of jotting down a running total of one’s contributions towards the savings account or receiving an automatic notification on their account balance.
Regularly monitoring savings helps to have a fair idea about one’s progress. One should also know how much money they still need to save to meet their savings goal. Moreover, one can set small goals and reach them. One must also pat their back for successfully sticking to their savings habit and reaching the saving goal.
Where Should I Keep An Emergency Fund?
Where one is to put their emergency funds solely depends on their situation. Nevertheless, one needs to be mindful of putting their hard-earned savings. The emergency fund should be easily accessible, safe, and in a place where one would not be tempted to spend the emergency fund in non-emergencies.
Three crucial aspects need to be considered while deploying an emergency fund, which is as follows:
1. Security
Since an emergency fund is meant to help one overcome a financially tough situation, one cannot put it anywhere. One should avoid putting in places where there is a chance of capital erosion in the short term. Hence, equity-based mutual funds or any such option having a proportionally high risk must be avoided.
2. Accessibility
Since emergencies demand immediate action, one needs to ensure that emergency funds are conveniently accessible.
3. Liquidity
Liquidity means how fast one’s investments can be converted to cash. Hence, long-term deposits, provident funds, bonds, and national savings certificates, which either have an upper withdrawal limit or are redeemable after maturity, must be avoided.
Following are some of the options where one can put their emergency money:
4. Cash
Another option is keeping the emergency fund in-home so it can be used as and when required. One can keep 15% of the emergency fund in liquid cash. However, one must be careful lest the money gets lost, stolen, or destroyed.
5. Bank Deposits
One can keep another 15% of the emergency fund in their bank account. It not only imitates the risk of speeding away money for unnecessary purposes but also keeps it safe. In addition to this, one can also earn a small amount of money as interest on the savings bank account.
Thus, 30% of the emergency fund kept separately at home and in the bank can be easily accessed and used for more minor emergencies.
6. Investment
The remaining 70% of the emergency fund can be invested in either liquid mutual funds or short-term deposits. Each of these debt instruments is highly liquid and has minimal risk. One can liquidate these investments through a bank’s app or a broker. Once liquidated, the funds will be deposited into their bank account within one or two days.
Liquid mutual funds have a slight advantage over bank deposits. For a liquid fund, the entry barrier is low. Unlike a fixed deposit, one can save a minimum amount to invest in a liquid mutual fund. Generally, the minimum amount that one would need to deposit to start with a fixed deposit is Rs. 10,000.
In addition, liquid mutual funds usually offer higher returns than standard bank deposits. It allows the investor to match the inflation rate, if not beat it. Lastly, the concerned bank might levy a premature withdrawal penalty on the fixed deposit if withdrawn prematurely. However, this is not the case with liquid funds.
Also, read: Investment Options: Top 15 Picks for 2023
When Should I Use It?
Merely having an emergency fund isn’t enough. One needs to be able to distinguish between an emergency and what is not.
Emergencies are always unexpected. This can be in the form of a medical bill you need to pay when you run short of cash. On the contrary, it is not an emergency if you run short of money to buy non-essential things such as going for a trip or a movie.
Hence, one must set specific guidelines regarding what qualifies as an emergency or unplanned expense. Each unexpected expense isn’t a dire emergency. However, all the probable types of situations where an emergency fund needs to be used cannot be listed all at once.
Nevertheless, listed below are four dire situations where one should not hesitate to use their emergency fund.
- To meet various financial obligations arising out of job loss. One never knows when one might have to lose their job. The recent COVID-19 and the consequent economic depression have led to job losses for many people. Hence, using their emergency fund is the only option unless one has an alternative income source. An emergency fund helps in meeting financial obligations, at least for a certain period.
- To take care of the medical expenses which aren’t covered by health insurance. A comprehensive Health Insurance Plan is undoubtedly the best way to combat medical emergencies. However, health insurance has its limitations too, and might not cover specific treatments. Hence, to meet those treatments’ expenses, one must rely on emergency funds.
- To meet the expenses related to emergency house repairs. Although home insurance is there to take care of such expenses there might be some expenses that are not covered by the insurance plan. Hence, one cannot help but use the emergency funds to cover expenses related to emergency home repairs.
- To take care of unexpected and emergency travel expenses. Last-minute travel tickets are generally quite expensive, whether travelling internationally or domestically. Hence, in such situations, emergency funds can be used.
Emergency Funds Calculation
Emergency funds are created to help you take care of financial demands that arise without prior intimation.
- Note down your monthly income: You have to include monthly income, your current salary, any second income, bonus, investment income, and any other income.
- Calculate monthly expenses note that monthly expenses include rent/mortgage, utilities, groceries, transportation, insurance premiums, loan payments, and other miscellaneous expenses.
- Determine the monthly amount spent on small expenses including dining out, shopping, movies, and small activities.
- Calculate the amount spent on travel including public transport and fuel etc.
- Evaluate the monthly amount spent including college fees, medical bills, family support, etc.
- Add Additional Expenses Include other monthly expenses like monthly subscriptions (gym, OTT services, etc.), gifting, insurance premiums, holiday expenses, recharge, etc.
Emergency Fund = Monthly Expenses x Number of Months
Finally, total your monthly expenses + recreational activities + amount spent on dependant + travel + other monthly expenses and multiply them by six. You know a lot of funds can be reserved for emergency funds.
Depends on how many month’s worth of expenses you want to cover with your emergency fund. The standard recommendation is usually between 3 to 6 months but it can depend on your risk factor. An emergency fund should be 6 times your monthly expenses. So, if you spend Rs. 40,000 per month, then your emergency fund should be Rs. 2,40,000.
Best Ways to Invest Emergency Funds
The best places for emergency fund investment are:
- A separate account other than your regular savings, so you won’t withdraw money regularly.
- A savings account that grabs the most interest possible.
- A readily available account for any emergency.
These are the key aspects of a high-yield savings account (HYSA). In a HYSA, you can earn high interest on your money and access emergency funds quickly without penalties or hassle.
A money market account is a special kind of savings account that can reward a higher interest rate to customers who save a large amount of money in their account. Money market accounts can provide a year of about 3% to 4% interest rate. Some banks offer money market accounts that come with a debit card which gives the facility instant access to your funds
CD stands for certificate of deposit. When you put money into this type of bank account, you’re telling the bank that you promise to let them hold onto your cash for a set amount of time. Your bank may offer a range of terms, commonly between a year and five years.
Generally, CDs get a higher savings rate than a standard savings account. However, one drawback of keeping an emergency fund in a CD, you usually incur a penalty for withdrawing funds before the CD matures. This makes it hard to access your money if required immediately.
Drawbacks of Emergency Funds
The primary drawback of emergency funds is that Investing money into an emergency fund reduces the chances of allocating any additional funds for different programs, such as paying down a mortgage or retirement money savings or paying down a mortgage. Thus, emergency funds may be overhead in achieving financial goals.
By adding money to the emergency fund, a person expects fewer chances for high returns. If you are expecting a high return on investment money in the stock market, bonds, or certificates of deposit. It may provide inflation-beating returns and allow your savings to grow through compound interest. Thus, emergency funds grab the opportunity to use one’s money to generate more wealth. Emergency funds allow the chance to leverage one’s money for wealth generation.
Conclusion
An emergency fund can be no less than a savior in times of economic crisis. However, an emergency fund needs to be dynamic. If one adds a family member or upgrades one’s lifestyle, their emergency fund should also reflect the proportionate changes in expenses.
To increase the limit of emergency funds, one can take up a side job. CheggIndia is one such company that offers remote opportunities to freshers, students, or professionals looking for part-time remote jobs.
One can join CheggIndia as a Q&A expert and earn a hassle-free side income from the comfort of their home. One can choose any subject they are proficient in, from Engineering, Business, Earth Science, Healthcare, Mathematics, and more. Solve questions posed by students and get paid for each accepted answer.
Frequently Asked Questions
There can be no definite answer to this question. Since, the size of one’s emergency fund depends on various factors such as income, number of dependents, lifestyle, existing debt, etc. Although, the general rule of thumb is to set aside anywhere between 3-6 months’ worth of essential expenditure.
If one has a family with kids and is the sole earning member, then the emergency fund ideally should be 12 months’ worth of essential expenditure. “Essential expenditure” refers to the expenses needed for day-to-day functioning.
These would include fixed costs such as rent, insurance premiums, school fees, mortgage payments, etc. It also includes variable expenses such as medicines, groceries, phone bills, and other incidentals.
The best thing to do with an emergency fund is to deposit it in a savings account. It is because a savings bank account guarantees the liquidity of the funds. Liquidity is of high importance for an emergency fund.
One can look for a savings account offering a reasonable interest rate. Moreover, there should be no minimum balance requirements or hefty maintenance charges.
The next best thing one can do with an emergency fund is to invest a part of it in a mutual fund that offers easy liquidity and guarantees better returns compared to a savings account.
Allocating a total monthly fund into a designated bank account helps to consistently grow and achieve the substantial savings you want. Preferably, you’d put your emergency fund into a high-yield savings account with high interest rates or you should use a savings account with a high interest and easy to cash that you’d need in an emergency.
An emergency fund is money that you keep on the side for a bad period. If you lose your job, your income stops and other misses happen but your expenses would not stop, the emergency fund comes in handy at that time.
1. You should always have 10% of the emergency fund available in cash.
2. You should have 20% of your emergency fund in your bank so that if it is earning 2-3%, you can access it anytime using a transaction.
3. And 70% of your emergency fund should be in a fixed deposit.
Elizabeth Warren popularised the 50-30-20 budget rule in her book All Your Perth: The Ultimate Lifetime Money Plan.
As per the rule, one must split their after-tax income into three categories in the ratio of 50:30:20. 50% of the after-tax income should be spent on needs and obligations. The next 30% must be spent on wants, and the rest 20% should be put aside as savings.
Bills and essential things that need to be bought for survival qualify as needs. Wants are the things one might want to spend money on, such as vacations or the latest electronic gadgets. The rest 20% should constitute savings and investments.
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