How To Build an Emergency Fund?
How To Build an Emergency Fund?
If there is one thing the ongoing coronavirus pandemic has taught us, it is that an emergency can strike at any time, and you can’t do anything about it other than being prepared. While an emergency such as a natural disaster like earthquakes, floods, a health condition that keeps you off from work, an economic downturn causing job losses and salary cuts, might not be under your control but ensuring you have enough funds to steer through is under your control.
How do you go about your life and meet your essential expenses in times like these? The answer lies in building an emergency fund that could help you sail through.
What is an Emergency Fund?
An emergency fund is a fund that should help you carry on with life and meet your obligatory expenses without opting for last-minute unplanned loans, overutilizing your credit card, or selling and mortgaging your existing assets.
For your emergency fund, you may need to factor in obligatory expenses which are those expenses that are absolutely necessary. Ideally, obligatory expenses include expenses for food and medical treatment, rent, monthly instalments of loans, school fees, basic repairs and maintenance, insurance premiums and anything that you feel is indispensable.
However, there is no standard definition for what qualifies as obligatory. For example, affording support staff such as domestic help and chauffeurs may be obligatory to some, many may find a gym membership impossible to forego even in times of financial distress. The bottom line remains you need to reserve enough funds to meet your obligatory expenses.
How to Save for an Emergency Fund?
Budgeting is the cornerstone of any financial planning. If you are just starting to build an emergency fund, you should follow three main steps.
- Record your monthly household expenses and categorize them into obligatory and discretionary expenses.
- Do it for a couple of months to get an average figure for your obligatory expenses.
- Conducting this exercise could also help you take stock of your expenses and sieving out non-essential spending.
If you are a single-earning member with dependent parents and school-going kids, you might want to save more considering unexpected medical expenses. If you add two-third of continuing loans, the saving figure would go up as you would have to pay your monthly instalments in addition to running your household.
Personal finance experts advise single-income families to build up a bigger emergency fund, often to meet fixed expenses (rent, monthly instalments) for one year and account for variable expenses for at least six months.
In case of a double-earning member family, the amount of savings per person could be lower.
How To Build Your Emergency Fund?
The amount of money required to save for your emergency fund may make you nervous and push you to shelve plans to start the activity. Before you give up, use simple strategies to be able to build the required financial corpus without over-worrying.
Set a target date for setting up your fund.
Setting a target date can be helpful in you reaching your goal faster. Depending on your current financial situation, set a date for achieving your goal for the emergency fund. It could be three months, six months or even a year. The earlier you start, the easier it is to collect the funds required.
Take stock of existing assets
You may already have some amount of assets that could be channelized to your emergency fund. It could be extra cash lying around in your savings accounts, some fixed deposits that are not linked to any particular goal, among others. You can allocate some of that amount towards your emergency fund.
Draw up a monthly commitment.
Depending upon what your shortfall figure is, which refers to the amount by which your requirement exceeds the funds you have, draw a monthly commitment towards your fund.
For instance, if your total fund requirement is INR 3 lakh and you have an existing fixed deposit of INR 1 lakh, you could pull INR 1 lakh from your existing savings and gather another INR 2 lakh.
An easy way to get the figure together is splitting it into a monthly commitment. If you have given yourself a 6-month target, then you would need to put aside INR 33,000 each month. Until you meet your goal, you might have to be extra frugal, but the strain is going to be worth the effort in the long-term.
Create a separate account for the accumulation.
There is always a temptation to spend when there is extra money lying around in your savings account. You could instead stash this extra money unrelated to any of your goals into a separate account created to accumulate capital for your emergency fund. You could do this simply by:
- Promising yourself not to withdraw any amount from this fund until you meet your target.
- Setting up an auto-debit feature on the account in which you receive your salary to ensure you met your monthly commitment towards the emergency fund.
- Scheduling the date for this transfer as close as possible to your income credit date so that you don’t get an opportunity to spend this amount on other discretionary expenditures.
Channelize any lump sum inflow into your emergency fund.
Putting aside any lump sum inflow like a bonus, income tax refunds, or gifts as credit that you receive, to meet your goal of creating an emergency fund at the earliest.
How To Secure Your Emergency Fund?
You have accumulated the amount required for your emergency fund; what do you now? Would it be ideal to let your funds stay in your savings account with a paltry 3% to 4% monthly savings return and see inflation erode the value of your money? Remember, it is a possibility that you may never use your emergency fund.
Here it is important to understand these funds are a part of your hard-earned money and should earn returns, irrespective of the purpose they are earmarked for. Just as it is important to save money for emergencies, it is equally important to park them in avenues that let you access these funds when you need them.
There are a few things that you should always keep at the back of your mind while parking your emergency funds.
- Safety and Security. The safety of your funds is of utmost importance as emergency funds are meant to help you sail through difficult times. You cannot be careless and park them in high-risk investments such as stock market-linked equities, futures and options investing, or in unorganized avenues such as chit funds. Although the returns in these categories are expected to be high, the chances of losing your capital are equally high.
- Ability to access the money at any time. Many emergencies may not give you enough time to react and make arrangements for cash. So it is imperative that you put your funds into avenues that are accessible without the requirement of complicated withdrawal processes. For example, many Indians hold gold in the form of coins or jewelry with an intention of making use of it at the time of emergencies. But selling or pledging your gold in times of emergencies could be cumbersome.
- Easier to withdraw. There are multiple safe investment avenues available such as the low-risk Public Provident Fund, long-term or tax-saving fixed deposits, National Saving Certificates or Recurring Deposits. But these kinds of investments come with a fixed tenure, penalties, and other attached conditions for premature withdrawal in times of emergencies. So, investing your emergency funds in these avenues may not serve the purpose.
- Do not mix up investment and emergency funds. It is necessary to maintain a clear distinction between funds meant for investment and funds earmarked for emergency use so that the decision on where to park these funds gets easier.
- Consider taxation. When you invest funds in various investment avenues, you may get taxed on the gains. 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: There is nothing like liquid cash to deal with emergencies. But it might not be the ideal avenue considering safety issues as well as zero return on a substantial amount of available capital.
Savings account with sweep-in facility: Many savings accounts allow you to have a sweep-in facility where amounts over and above a set limit are channeled into a fixed deposit. But if you ever need the cash, nothing stops you from withdrawing any amount post payment of 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 money saved in a savings account, you could open short-term fixed deposits with your bank. When choosing this option, it would be useful to understand the terms and conditions before opening a deposit account.
Liquid mutual funds: Liquid mutual funds fall in the category of debt mutual funds. These funds invest in short-term fixed-income securities like Certificates of Deposits, Term Bills, among others. Liquid funds offer a slightly higher return than fixed deposits and are more liquid. The low minimum investment criteria is another positive factor.
It’s important to know liquid mutual funds carry an exit load when redeemed before seven days and are subject to short-term capital gains at your income tax slab when redeemed before three years. The redemption amount may take up to a day or two to be deposited in your account.
Considering the fact that each of these investment avenues behaves differently, it might be good to split up your emergency funds among them based on your comfort level. You could consider splitting your fund in the ratio of either 20:20:60 or 20:30:50 among cash, savings with a sweep-in facility, and short-term deposits or liquid mutual funds so that your emergency fund remains accessible as well as earns returns.
An emergency fund is like your parachute that saves you from a freefall in the event of a financial crisis. So, always give it the importance it deserves. It would be useful to keep reviewing your emergency fund requirements at least once a year, as there may be changes in your life like starting out a business, taking a sabbatical from work, addition of a new family member or a change in your lifestyle.