What Is An Emergency Fund and How to Build Emergency Funds?

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Unexpected circumstances such as car repairs, medical emergencies, job loss, home repairs, etc., demand immediate financial attention. If you are not financially prepared to tackle such unforeseen situations, you can easily deplete your savings, put a massive strain on your cash flow and derail your financial plans. Therefore, building an emergency fund is a preventive measure you can take to stay prepared for financial emergencies.

What is an Emergency Fund?

An emergency fund is a contingency fund exclusively built to tackle unforeseen events and situations requiring urgent financial commitments. The emergency fund is built by putting aside a part of your income to tackle unexpected expenses without disrupting your financial goals and straining your cash flow.

Importance of an Emergency Fund

An emergency fund is your safety cushion; you can fall back on it in times of crisis – unanticipated and unplanned situations – for meeting your financial shortfalls.
Some of the scenarios where you may need an emergency fund are:
  • Job loss
  • Pay cut
  • Car repairs
  • Relocation due to new job
  • Home repairs
  • Unexpected bills or unpaid bills
  • Medical emergency or medical expenses that are not covered or not fully covered by the health insurance plan
  • Death in the family that requires you to cover the funeral and other associated costs
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How Much Emergency Fund Should I Have in India?

Financial experts recommend having an emergency fund that can cover three to six months of your living expenses without any income. The recommended amount to get started with beginner emergency amount is ₹1 Lakh to ₹1.5 Lakh. Some experts recommend having as much as your yearly salary or more in your emergency fund.
That said, every person has different financial needs, and it depends on their lifestyle, income, dependents, and unavoidable monthly expenses.

Hence, the right emergency fund amount differs from person to person. When calculating the emergency fund amount, it’s important to consider the minimum amount you need to get through your monthly expenses. These expenses include electricity bill, loan repayments, home loan, rent, etc.

Given the current pandemic situation we are in, 6 months to 1 year of basic living expenses stashed as an emergency fund is a must. For example, if you earn ₹30,000 a month and ₹15,000 is your basic living expense, then your emergency fund should be in the range of ₹60,000 to ₹1,00,000.

You may even divide your emergency fund into 2 categories:

  • For long-term goals

    This fund can be used for huge emergencies like a major natural disaster or a sudden medical emergency. Invest this fund in financial instruments that allow you to earn slightly higher returns and which can be liquidated within a couple of days’ notice.

  • For short-term goals

    This is your rush-to fund when in an emergency. Invest this fund in saving vehicles where immediate accessibility and not high return is your priority.

Why Keep Emergency Fund Liquid?

Your emergency fund should be in a position to cover unexpected expenses, and that’s the reason why it needs to be liquid. The three things you need to keep in mind when deciding where to park your emergency funds are:
  • You should be able to withdraw money when you need it without any delay.
  • There should be no penalty for early withdrawal.
  • The amount you invest in an emergency fund should be able to deliver good returns.

How to Build an Emergency Fund?

  1. Determine the Fund Amount You Need

    Deciding the right amount to set aside for emergencies requires a disciplined approach: Here’s the best approach to help you get started:

    • Evaluate your monthly income inflow and outflow, which will give you a clear idea of how much to save.
    • Try to curtail additional expenses and find out more ways to save.
    • Put additional money to work by investing it.
  2. Choose the Right Investment Options

    Once you have determined the amount to be put aside in the emergency find, it is important to find the best saving instrument to keep it.

    When investing in creating an emergency fund, it is best to choose the right investment options that are:

    • Easily accessible
    • Earn higher returns on your savings
    • Safe from market fluctuations
    • Stable and reliable

    Where to Park Emergency Fund?
    Some of the best investment options are as follows:

    • Savings Account: You can easily open a savings account with a bank to keep your emergency fund. Although savings account guarantees easy liquidity, the returns of the invested funds are low.
    • Chit Fund: Parking your emergency fund in a chit fund ensures quick liquidity as well as good returns compared to a bank savings account. For safe and secure investment, invest using digital chit fund app like The Money Club.
    • Mutual Funds: If you have healthy savings, stable income and are in a position to afford market fluctuations, you can consider investing in mutual funds. ROI can be high, but it is a risky investment.
    • Fixed Deposit and Recurring Deposit: These investment options offer quick liquidity and a higher interest rate than a savings bank account. But, pre-withdrawal from these accounts can attract a penalty.

  3. Automate Your Investments

    When creating an emergency fund, it is wise to set up an automatic transfer from your primary account to your emergency fund account.

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An emergency fund can make a world of difference in emergencies and prepares you against financial shortfalls. Remember, like any other financial plan, you need to regularly revisit your emergency financial plan and make changes accordingly. Keep in mind that even though an emergency fund should be liquid, it is not something you can access often. So, don’t dig into it for your routine expenses.