If there is one thing the past three years of the pandemic has taught us is that unprecendented, once-in-a-lifetime events can occur in your lifetime and there is nothing one can do about them except be prepared for them. Emergencies often don’t have to be as serious as a pandemic to put you through a sudden financial crisis. You may suddenly lose your job or your house needs unexpected repairs, or your family member has met with an accident and the medical bills are not fully covered by your insurance... Such situations may force you to take a loan, max out your credit cards, or worse, liquidate your assets. An emergency fund can help you steer clear of such situations.
What is an emergency fund?
As the name suggests, an emergency fund is a fund for any unexpected situation or emergency to help you live your life without having to take last-minute loans or liquidate your assets. They are not for one particular situation, but for any situation where you might to spend more than your normal expenses for which you haven’t budgeted.
Do I really need an emergency fund?
You may argue that you already have insurance and other investments which may help you in times of need. But insurance doesn't cover everything, and even if it does, what are the chances that you will actually get the cover you desire? Insurance companies have only 1 target: To payout as little as possible. In the very probable case that your insurance doesn't cover your expenditure, where will you get the money from?
Besides, there are emergencies like losing your job that no insurance covers. In this case, only an emergency fund will help you.
How to build an emergency fund?
We really can’t predict what type of emergency may befall you or how long it will last. But an ideal emergency fund should atleast help you stay afloat for three months. If you the sole breadwinner of the family, consider increasing this to six months.
But how much do you need to save?
When I say you have to stay afloat for six months, an easy answer for how to save would be to save money equivalent to your six months’ salary. But it can be very difficult to save this much money quickly enough. If it was easy, you would have done it already.
The next best thing you can do is save enough to meet your 3-month or 6-month obligatory expenses, meaning expenses which you MUST pay for each month. These include groceries, electricity and phone bills, rent, insurance premiums, SIP installments (very obligatory, do not miss these), school and tuition fees, transportation costs, EMIs, etc.
If you make a fund enough for these, you’d be sure to atleast keep your household working while you look for something else. If you haven’t lost your job in your emergency, this emergency fund will help you continue your non-discretionary expenses while you can divert your salary towards the crisis standing before you. Either way, you won’t need to ask money from someone or sell your assets at the wrong time.
So how can you build an emergency fund?
You can build your emergency fund by the following steps:
Step 1: Find out how much obligatory expenses you incur on average each month, and then multiply it by 3 or 6. This becomes the amount in your emergency fund.
Step 2: Find out how much money you already have lying around. This may be money just idling away in your saving account, or money that you invested in something that is liquid or maturing, or cash in your home. Wherever you find money that isn’t being used well, take it into your emergency fund. Remember, the faster you build this, the better it is for you.
Step 3: If you still have some money left from your fund, decide a timeline until which you will complete saving the rest. Faster the better.
Step 4: Once you know the timeline, take out some part of your monthly salary into the fund. Do not delay the target at any cost.
Step 5: Continue building the fund, even if you have enough saved. Remember, we are just estimating. The emergency may be bigger than you expected. Make the emergency fund your piggybank. Any money you have lying around, any bonus, any gift, any additional income, put it in the fund. Let it swell.
Now that we know what an emergency fund is and how to build it, the next and possibly the most important question is:
Where to build your emergency fund?
Based on your expenditure, loving standards, and the duration you considered for the emergency fund, it may be a substantial amount. The easiest option would be to keep it all lying around in your house as hard cash. I mean, it's almost intuitive, isn't it? "I am going to use it for emergencies. What better place to keep it than my own house where I can take it out any day I want?"
But there are multiple problems with this approach:
1. It's cash. And stashing cash in your house comes with many security issues. That's why we keep our cash in bank lockers. Maybe, you'd say "Then I'll keep it in my locker". But it doesn't solve the other problems.
2. For the same reason that you thought of keeping your fund as cash (very liquid; can be taken out any day you wish), you shouldn't keep it as cash. Because if it just lying around, you will be enticed to spend it for other things which are not emergencies.
3. And the most important drawback: cash loses its value over time due to inflation, duh! There is a possibility that you might not ever use your emergency fund . Do you want such a sizeable amount lose its value over a long time?? I hope not.
What other options do you have? Savings account which hardly beat inflation? I don't think so.
Fixed deposits? With fixed tenures and low liquidity, they may not be a good option for your emergency fund.
Provident funds? Same problem as the fixed deposits.
The best option would be to put them in liquid instruments which give good returns beating inflation. The best options would be liquid mutual funds, debt or equity. I suggest using an index fund that takes away a lot of problems of choosing active funds. These also have very little expense ratios. So you will make returns equivalent to the market and have easy redemption as well. Or you may use a tax saving active fund to save on some taxes while redemption.
Bottom line:
An emergency fund can work as a lifesaver when you need money the most. It is important to plan and create an emergency fund based on your expenses and living quality. Parking the money in a liquid, market-linked mutual fund or index fund can help grow your fund when you are not using it. If you ever feel the need to consume it, remember to build it again.
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