If there’s one thing we have learned from the ongoing coronavirus pandemic, it’s that an emergency can happen at any time and there is nothing you can do about it other than being prepared. Although an emergency such as a natural disaster such as an earthquake, flooding, a health problem that prevents you from working, an economic downturn resulting in job losses and wage cuts, may not be under. your control, but ensure that you have sufficient funds to pass through your control.
How do you live your life and meet your essential expenses at times like these? The answer lies in building up an emergency fund that could help you navigate through it.
What is an emergency fund?
An emergency fund is a fund that should help you get on with your life and meet your mandatory expenses without going for unscheduled last minute loans, overusing your credit card, or selling and mortgaging your existing assets.
For your emergency fund, you may need to factor in mandatory expenses which are absolutely necessary expenses.
Ideally, mandatory expenses include expenses for food and medical treatment, rent, monthly loan payments, tuition, basic repairs and maintenance, insurance premiums, and anything else you feel is essential.
However, there is no standard definition of what is considered mandatory. For example, providing support staff like housekeepers and drivers may be mandatory for some, many may find it impossible to forgo a gym membership even in times of financial distress. The bottom line is that you need to set aside enough funds to cover your mandatory expenses.
How to save for an emergency fund?
Budgeting is the cornerstone of all financial planning. If you are just starting to build an emergency fund, there are three main steps you need to take.
- Record your monthly household expenses and categorize them into mandatory and discretionary expenses.
- Do this for a few months to get an average figure for your mandatory spending.
- Running this exercise can also help you take stock of your expenses and sort out non-essential expenses.
You can never predict how long an emergency may last, so it’s ideal to build an emergency fund that could help you go on for at least 3-6 months.
Suppose your compulsory household expenses are INR 50,000 per month. In this case, your emergency fund should contain between 1.5 lakh INR and 3 lakh INR at one time. This could change depending on the number of earners in your household, the number of dependents and your expenses.
If you are a single income member with dependent parents and school children, you may want to save more for unforeseen medical expenses. If you add two-thirds of the outstanding loans, the savings figure will increase because you will have to pay your monthly payments in addition to managing your household.
Personal finance experts advise single-income families to build a larger emergency fund, often to cover fixed expenses (rent, monthly payments) for a year and account for variable expenses for at least six months.
In the case of a dual income family member, the amount of savings per person may be lower.
How to build up your emergency fund?
The amount of money needed to save for your emergency fund can make you nervous and cause you to put aside your plans to start the activity. Before giving up, use simple strategies so that you can build the required financial body without worrying too much.
Set a target date for the creation of your fund
Setting a target date can help you reach your goal faster. Based on your current financial situation, set a date to reach your goal for the emergency fund. It can be three months, six months, or even a year. The earlier you start, the easier it is to raise the necessary funds.
Take stock of existing assets
You may already have a number of assets that could be funneled into your emergency fund. These could be extra cash lying around in your savings accounts, certain term deposits that aren’t tied to any particular purpose, and more. You can allocate part of this amount to your emergency fund.
Establish a monthly commitment
Depending on the amount of your shortfall, which refers to the amount by which your needs exceed the funds you have available, take a monthly commitment to your fund.
For example, if your total fund requirement is 3 lakh INR and you have an existing fixed deposit of 1 lakh INR, you can withdraw 1 lakh INR from your existing savings and collect another lakh INR.
An easy way to get the number is to break it down into a monthly commitment. If you have set a goal of 6 months, then you will need to set aside INR 33,000 each month. Until you reach your goal, you may need to be very frugal, but the strain will be worth it in the long run.
Create a separate account for accumulation
There is always a temptation to spend when there is extra money lying around in your savings account. Instead, you can put this extra money unrelated to any of your goals in a separate account created to build up capital for your emergency fund. You can do this simply by:
- By promising you not to withdraw any amount from this fund until you reach your goal.
- Setting up a direct debit feature on the account you receive your salary from to ensure you meet your monthly emergency fund commitment.
- Set the date of this transfer as close as possible to the date of your income credit so that you do not have the option of spending this amount on other discretionary expenses.
Channel any lump sum influx into your emergency fund
Set aside any lump-sum entry like a bonus, income tax refunds, or credit gifts that you receive, to achieve your goal of building an emergency fund at the earliest.
How to secure your emergency fund?
You have accumulated the amount required for your emergency fund; what are you doing now? Would it be ideal to let your funds sit in your savings account with a paltry 3-4% monthly return and watch inflation erode the value of your money? Remember, you may never use your emergency fund.
Here it is important to understand that these funds are part of your hard earned money and should generate returns regardless of what they are for. Just as it’s important to save money for emergencies, it’s just as important to park them in avenues that allow you to access those funds when you need them.
There are a few things you should always keep in mind when parking your emergency funds.
- Safety and security. The safety of your funds is of the utmost importance as emergency funds are meant to help you get through tough times. You cannot be sloppy and place them in high risk investments such as stocks linked to the stock market, futures and options, or in unorganized avenues such as chit funds. While the returns in these categories are expected to be high, the chances of losing your capital are just as high.
- Ability to access money at any timee. Many emergencies may not give you enough time to react and make cash arrangements. It is therefore imperative that you invest your funds in accessible ways without requiring complicated withdrawal processes. For example, many Indians hold gold in the form of coins or jewelry with the intention of using it in an emergency. But selling or pledging your gold in an emergency can be tedious.
- Easier to remove. There are many avenues of safe investment such as the low-risk public provident fund, long-term or tax-saving fixed deposits, national savings certificates or recurring deposits. But these types of investments come with a fixed duration, penalties and other conditions attached to a premature withdrawal in an emergency. So investing your emergency funds in these avenues may not serve the purpose.
- Don’t confuse investment with emergency funds. It is necessary to maintain a clear distinction between funds intended for investment and funds intended for emergency use so that the decision on the location of these funds is easier.
- Think about taxation. When you invest funds in various avenues of investment, you may be taxed on the earnings. So choose avenues where you can balance the tax implications.
Where to park your emergency funds?
Some of the options available to you are:
Cash: Nothing like cash to deal with emergencies. But this may not be the ideal solution given the security concerns as well as zero return on a substantial amount of available capital.
Savings account with possibility of transfer: Many savings accounts allow you to have a transfer facility where amounts exceeding a set limit are routed to a fixed deposit. But if you ever need the money, there’s nothing stopping you from withdrawing an amount after paying the penalties, if any. This way your fund will earn something more than a savings account.
Short-term fixed deposits: If you are worried about spending the saved money in a savings account, you can open short-term term deposits with your bank. When choosing this option, it would be helpful to understand the terms and conditions before opening a deposit account.
Liquid mutual funds: Liquid mutual funds fall under the category of debt mutual funds. These funds invest in short-term fixed income securities such as certificates of deposit, term bonds, among others. Liquid funds offer a slightly higher return than fixed deposits and are more liquid. Another positive factor is the low minimum investment criterion.
It is important to know that liquid mutual funds have an exit charge when redeemed before seven days and are subject to short-term capital gains to your income tax when redeemed before three years. . It may take up to a day or two for the redemption amount to be deposited into your account.
Considering the fact that each of these investment avenues behaves differently, it might be a good idea to split your emergency funds among them based on your comfort level. You can consider dividing your fund in the 20:20:60 or 20:30:50 ratio between cash, savings with easy transfer, and short-term deposits or liquid mutual funds so that your fund emergency remains accessible as well as earns returns.
Final result
An emergency fund is like your parachute that saves you from a free fall in a financial crisis. So always give it the importance it deserves.
It would help to continue to review your emergency fund needs at least once a year as there may be changes in your life like starting a business, taking a sabbatical from work, adding a new family member or a change in your lifestyle.
