Home » How to build an emergency fund and the benefits?

How to build an emergency fund and the benefits?

How to build an emergency fund and the benefits?

Photo courtesy Diane Helentjaris on Unsplash.

An emergency fund is money that people stash away monthly or in a year from their incomes to meet the obligations arising in case of financial distress.  It creates a safety net and is part of sound financial planning. It reduces the need for unplanned loans, selling your assets, or over-utilizing the credit card.

The emergency fund should be easily accessible and should be around six months of the expenses. The last two years have been very bad for the world financially as well as on the health aspects. Due to the Covid-19 pandemic, there have been frequent lockdowns and many people have lost their jobs and a large number of small businesses have been affected. This has led many experts to suggest having funds worth one year’s expenses.

Why do you need an emergency fund?

An emergency fund helps in preventing you from going into debt and gives you peace of mind. The reasons why you should work on having an emergency fund are-

  • If you have a family and everyone is dependent on income of a single person the emergency fund can help you in case of job loss until you find a new job. If can also help during your illness or family members illness.
  • When you are self-employed there are times when your business may be slow. You have to keep these months in mind and save money.
  • When you have a house there are many repairs that may arise and things do keep breaking. The repairs can be quite costly so it is better to save money in the emergency fund. If you live in an area prone to flooding or hurricane then it always better to save some extra money.
  • A serious medical issue can be costly and your insurance company may not clear all the bills. You will then be forced to pay from your pocket and if you are in a job a long illness may make you run out of sick pay leave. Emergency fund will be helpful during these times. Looking at the present conditions we can see quickly the coronavirus has increased the medical expenses of affected persons.
  • When your near relative is in medical emergency you have to arrange for tickets. Besides this you have to often attend marriage functions of your near and dear ones who reside far away so you always require some funds stashed away.
  • An emergency fund can help you cover things that you did not plan for like the car repairs. As you start budgeting there may be many unplanned expenses and you can write them down and include in your future house budget.

Where should you keep the emergency fund?

An important factor you should keep in mind when allocating funds for emergency situations is that it should be liquid, to cover for unexpected situations. You should be able to withdraw the money when you need it the most without any delay and at the same time, you should not be penalized for the withdrawal. There are a few options available and some of the options are-

  • Cash is very important in dealing with emergencies but it is not the most ideal idea to keep large amount of cash due to the safety concerns. The other thing is that there are no returns on the cash that you have kept idle.
  • You can also park the money in a savings account.
  • There are short term fixed deposits in the bank where you can keep the money, if you are apprehensive of keeping money in savings account from where you may spend the money due to its easy accessibility. But do understand the terms and conditions before opening this account.
  • The money can also be deposited in liquid mutual funds that are a type of debt mutual funds. Returns are slightly higher than fixed deposits and liquidity is good. But these liquid funds are subject to short term capital gains.

You can even divide the fund into two categories. The long-term emergency fund for sudden medical emergencies or natural disasters can be invested in instruments with a slightly higher rate of return which may take a few days to liquidate and the short-term emergency funds that offer fewer returns but are easily accessible. You can take funds from the short-term liquid funds for urgency till the long-term fund is liquidated.

Once you withdraw from the emergency savings you should always contribute the money back to save for the next emergency.

How to build an emergency fund?

The emergency fund can be built with some proper planning. The steps that can be taken are-

  • Plan for a date by when you will be able to set up the fund. Planning helps to reach the goal faster and the date could be six months to a year from the date now.
  • You can even allocate some of the extra cash lying in your saving account.
  • Start a monthly budget where you will be able to find your monthly expenses. This will make everything clear how much you should spend and how much you should allocate for emergency purpose.
  • Record your household expenses and categorize them into essential and discretionary. A couple of months of recording will give you a clear picture on the obligatory and discretionary spending patterns. You can cut down on the non-essential items and divert the money towards emergency fund building.
  • You can create a monthly commitment. Suppose you plan to have a total requirement of Rs. 2 lakhs in emergency fund you can split it in six months and save the money.
  • Once you have saved the money for the emergency fund you will have to keep yourself in check. You may be tempted to spend this money on the other things which is not a good sign. What you can do is to stash this amount in a separate account.

Things to keep in mind when parking money for the emergency fund-

  • The fund should be easily accessible as an emergency situation requires easy availability of money. There should not be any complicated withdrawal procedure that takes long time. Always study the penalty attached in case of early withdrawal.
  • The fund should be safe and secure and never put in risky instruments like stock markets or bit coins. The chances of losing capital are high there.
  • Have a clear thought process and distinction on the fund meant for investment and the one that needs to be stashed away for emergency.
  • Study the tax implications of the instruments where you consider investing.

There are many benefits of this associated with emergency funds-

  • Saving for an emergency fund organizes your spending and saving habits. You become aware of the essential and discretionary expenses. There are some expenses that you can avoid for a better future.
  • When you are aware that you have money stashed for emergency situation it gives you a peace of mind.
  • The medical emergencies are one of the reasons to keep emergency fund. It may arise suddenly without any warning and then you will require money. Having money during this time is very helpful.

It is clear by now that keeping an emergency fund is essential. Emergencies situations will be a stressful time and having money during this time reduces some tension. You should plan and keep the emergency fund in liquid instruments from where you can withdraw the amount easily. So it is advisable to start saving for the fund as soon as you start earning.

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