We either save up cash, or invest in stocks or mutual funds to realize our dreams, sometimes having different investments for different goals, which is a great idea. But despite all the planning for the future, sometimes there is a gaping hole that most of us miss completely, or just overlook.
This gaping hole is the one that should be filled by what is termed as an emergency fund. Yes, that house or car is important, but there is nothing that prepares you for emergency situations as well as an emergency savings fund can.
There is no other choice but to make it a top priority, giving it first preference over everything else. But, what is an emergency fund, how much should it be and how does one begin building it? Let us look, in detail, at all the answers to these intriguing questions.
What is an emergency fund?An emergency fund is an amount of saved cash that you can access immediately and use it for unforeseen emergencies. It can be anything from an unplanned trip to the hospital to the sudden loss of a job. An emergency fund is something that can give a last minute saving grace when you’re in a tight situation. And its importance cannot be stressed enough.
Medical emergencies come without knocking on the door, and an emergency fund will completely alleviate the panic that comes hand in hand with such emergencies. When you know that you have some funds saved up for such unwanted events, you also have peace of mind. You will know that you can handle anything that comes your way.
What constitutes an ‘emergency’?You may have already built your emergency fund, or are planning to build one. Either way, it is very important to first be clear on the concept of an emergency. What can be termed as an emergency and when should you use the emergency fund is a question that many of us want an answer to.
A significant sum of money that is within arm’s reach is something that can be tempting to use when you don’t actually need it.
Examples of an emergency:
- Loss of your job
- An unplanned visit to the emergency ward
- A road accident
- Travelling to visit a sick family member
- Travelling to attend a funeral after the demise of a family member
- Car damage or breakdown
- Malfunctioning of major home appliances
- Major damage to the house or other property
- Replacing your broken laptop or phone can also be considered an emergency, especially if your job or business requires its use and you can’t do without buying a new one
What is not an emergency?Now that we know what an emergency can be, it is also important to know what does not constitute an emergency. This will help you decide, with better clarity, whether you should be using your emergency fund for these purposes.
Examples of a non-emergency:
- A broken home appliance that does not warrant an expensive replacement. Your TV may be broken, but that does not mean you need to get a brand new, top of the line flat screen TV as a replacement by using your emergency fund.
- Planned purchases like a home or car
- Purchases that are made solely for your entertainment, which means they are something you don’t necessarily need, but want.
Key features that an emergency fund must haveWhen you build your emergency fund, it is necessary to make sure that the fund meets a few criteria, so that it can be convenient to use.
An emergency fund should be liquidThis means that the emergency fund that you have accumulated must be accessible to you as liquid cash. You cannot assign a property you own, or a long term investment, as an emergency fund. Because it will take time to liquidate your investments, and an emergency fund is something you will need instantly. On the other hand, your funds in a savings account are fully liquidated already, and thus accessible with a simple swipe of your ATM card.
It should be accessibleYour emergency fund should be easily accessible to you, which means that a few thousands in your safety deposit box at the bank is not a good idea for an emergency fund. If you need it at midnight, with the bank closed, there is no way to access it. Keeping some at home is a much better idea, but the majority of it is best kept in a savings account with a debit card.
It should be saved/invested in a risk-free mannerThere is no cardinal rule that says that you must never invest your emergency fund. When you’ve accumulated enough, you can practice emergency fund investment for a part of the amount. But it must be a low risk and short-term investment that you can liquidate quickly.
You do not want to lose your emergency fund to volatile markets, so keep your emergency fund away from stocks. But then, where to put emergency fund? Save most of your emergency fund in a savings account, where you will receive some interest on it, even if it is low. Save a small part as cash in your home, and invest the rest.
How much should I save for an emergency fund?Coming to the big, important question of the amount you need to save as your emergency fund. The best answer is that it is different for different individuals, since it depends on your monthly expenses and requirements.
A good rule of thumb is that you should have an emergency fund that is about 3 to 6 times your monthly salary. This will help you run your home for 3 to 6 months even when you’re out of a job while also contributing to other emergencies.
How to build an emergency fund?Now that you know what an emergency fund is, let us find out how to build one. Of course, it is not easy to simply keep aside that significant amount as an emergency fund, unless you have surplus cash. You have to think of it as an investment, and build it bit by bit, as follows:
Start making small contributionsThe first step in building emergency fund is to have a goal in mind. Calculate the amount you need for your emergency fund and find out how much you can contribute every month. This way, in a couple of years, you will have a sizeable fund ready.
Use auto-payment optionsContributing to an emergency fund, when there is no emergency yet, can sometimes feel unnecessary. But it is not. If you’re making monthly contributions, you may feel, once in a while that there would be no harm in skipping your contribution that month. To counter this, schedule automatic payments from your regular account to the emergency fund.
Divert your leakage to the emergency fundThere is a leakage or wastage of money in every household. It is a phenomenon that completely flummoxes you, because you have just spent some money and you do not know where it went. It could be that aisle in the supermarket where you indulged in your favourite food at once, or at the restaurant where you ordered more than you could consume.
Find the leaks, put a bucket under them and then pour that bucket into your emergency fund.
Save tax-refundsIt is an excellent idea to save your tax refunds in your emergency fund account. In your mind, you have already paid the tax, and at the end of the year, when you receive your tax refund on your investments or other tax deductibles, then assume that it is a bonus and direct it into your emergency fund.
Save your changeYou bought your groceries at the local store, and the bill turned out to be Rs. 87. You paid with a crisp 100 rupee note and the cashier returned the remaining 13 rupees in coins. Chances are that these coins ended up on the bottom of your washing machine or are still lying under your pillow.
Why not save these? These may not seem like much, but if all the members of your family collected their change, it would be a small contribution. Collect small change in a jar and at the end of every month, empty this jar into your emergency fund.
Final wordBelieve us, having an emergency fund is a soft cushion that can help you in more ways than one in times of stress. When you’re between jobs, you can use it for your monthly expenses and carry on as before for a few more months till you find a new job. The future brings with it some unforeseeable situations. The peace of mind that an emergency fund can provide to handle such events is simply unparalleled. Start building yours today.
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The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.
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