When you start a road trip that you have been looking forward to, no matter how enjoyable you want it to be you always ensure that you are carrying a stepney (a spare tyre) just in case of a flat tyre. Without a stepney, a flat tyre can leave you stranded on the road causing inconvenience, delays and unforeseen expenses. Similarly in the journey of life, we should be ready for any unexpected expenses that can cause financial stress, hardships and even debt. This is where Emergency funds come in handy.
Having a stepney doesn’t guarantee you won’t get a flat tyre, just as having an emergency fund doesn’t guarantee you won’t face financial difficulties, but having a stepney does provide a sense of security and preparedness, just as having an emergency fund gives a sense of financial security and peace of mind.
Emergencies are unpredictable and can strike at any moment, often leaving us feeling overwhelmed and unprepared. Financial emergencies, in particular, can be especially challenging to manage, with unforeseen expenses such as medical bills, car repairs, job loss or home maintenance that can leave us struggling to make ends meet.
What Is an Emergency Fund?
An emergency fund also called as Rainy day fund, is a pool of money that is set aside specifically to cover unexpected expenses or emergencies. It acts as a financial cushion that can help you stay afloat during tough times, without having to rely on credit cards or loans that can add to your financial stress in the long run.
Why Do You Need an Emergency Fund?
Emergency fund is a very important tool used in Personal finance and money management .Here are some of the main reasons why you need an emergency fund:
- Job Loss: Losing your job can be a significant setback, especially if you don’t have a backup plan. An emergency fund can help you cover your expenses while you search for a new job.
- Medical Emergencies: Medical expenses can add up quickly and often come at a time when you least expect them. Having an emergency fund can help you cover these expenses.
- Any unexpected situation: Sometimes the emergencies can be for a good cause like a sudden vacation plan coming up, or a friend’s destination wedding which can burn a hole in your pocket.
- Natural Disasters: Natural disasters such as floods, earthquakes, or hurricanes can cause significant damage and often require expensive repairs. An emergency fund can help you cover these costs without having to take on debt.
How BIG should your emergency fund be?
The amount you should save in your emergency fund depends on your personal circumstances. Generally, it is recommended that you save between six to twelve months’ worth of living expenses. However, this number can vary depending on factors such as job security, health, age and other financial obligations.
To calculate your emergency fund, start by calculating your monthly living expenses. This should include all essential expenses such as rent, EMIs, utility bills, food, transportation, and any other necessary bills. Please ensure that this total amount includes only your needs and not your wants. Once you have this number, multiply it by the number of months you want to save for which generally is 6 months and ideally should be 12 months.
Take a look at the below example;
|5||Personal Expenses -dining out, movie etc||3,000.00|
|Monthly Expenses excluding personal expenses||25,000.00|
|Emergency Fund 6 Months 25000 x 6||150,000.00|
|Emergency Fund 6 Months 25000 x 12||300,000.00|
In this case you calculate your total expenses excluding your expenses on wants like dining out or movie nights and include only your Needs and then arrive at a value for 6 or 12 months.
How to Create an Emergency Fund?
Creating an emergency fund is easier than you think. Here are some steps you can take to get started:
- Start Small: Building an emergency fund can be daunting, especially if you’re starting from scratch. However, you don’t need to save everything at once. Start small and work your way up.
- Make a Budget: Creating a budget can help you identify areas where you can cut back on expenses and free up money to save for your emergency fund.
- Automate Your Savings: Set up an automatic transfer from your inflow account to your emergency fund every month. This way, you won’t have to remember to transfer the money manually.
- Keep Your Emergency Fund Separate: Keep your emergency fund in a separate account from your regular savings account. This will help you resist the temptation to use it for non-emergency expenses.
- Revisit Your Emergency Fund Regularly: Your emergency fund needs can change over time. Revisit your emergency fund regularly and adjust it accordingly.
Where to keep your Emergency Fund?
When it come to where to keep your emergency fund, it is important to prioritize safety, liquidity and accessibility. Here are some options to consider:
- Cash: At least 10 -15% of your emergency fund should be kept as cash in hand as it will be the most easily accessible when required.
- Saving Bank account: This is another safe and easily accessible way of keeping your emergency fund. However the interest rates on saving bank account are generally low which means your money may not earn much return for you. Around 20% of emergency fund can be parked here.
- Liquid funds: Keeping balance of your money in liquid funds is a good idea as they are low risk investments and may earn a better return. Liquid mutual funds have zero exit load making them a preferred option over fixed deposits (FD) as a premature closure of FD has some charges. When you want your money back, you may redeem them as they have less settlement time of T +1 days.
Mistakes to avoid with your emergency fund
- Choosing wrong investment options: As a rule emergency fund should not be invested in high risk avenues or investments where there is a lock in period.
- Using the funds for non emergency situation: The fund has been created only for contingency and should never be used for other lucrative situation like planning a vacation or buying an expensive gadget.
- Not reviewing your emergency fund: It is important to review your emergency fund regularly as there are always new situations coming up as live moves ahead. There will be new responsibilities like children, their education, marriages etc for which you will have to be better prepared.
- Not restoring after using the funds: In case you have utilized the fund in full or in part for some emergency, it is important to replenish it to the adequate level.
- Not adding any lump sum income to fund: It is a very good practice to add any lump sum income to emergency fund, like a bonus, a cash gift or any windfall earning.
In conclusion, having an emergency fund is an essential component of a sound financial plan. It provides a safety net, a cushion and ensures you have peace of mind. By prioritizing savings and keeping in mind the points mentioned on the blog you can build a robust emergency fund that will protect you from any financial hardships. Remember it’s never too late to start saving for your emergency fund. So take action today and start building one for your financial security.