Synopsis: Having an emergency fund to be used in times of need is a no-brainer. Ideally, it should be three to six times your monthly expenses. Continue reading to know more about its importance and how to build one.

Emergency funds help you cover financial obligations in emergencies, such as job loss, a medical emergency,  and so on without derailing your financial or mental well-being. Plus, it prevents the need to resort to high-interest loans or depleting long-term savings.

You can choose the type of emergency fund you want depending on your goals. For example, if you’re saving for a medical emergency or wedding, your emergency should have a longer liquidation date and higher interest. But, if you’re saving for small expenses — car repairs, home maintenance — you want funds that provide immediate accessibility.

Read along as we discuss more about emergency funds, their importance, how big they should be, and where to park your emergency fund.

Understanding The Need For An Emergency Fund

Emergency funds ensure financial stability by acting as a resilient safety net in times of uncertainty. Here are some common situations where having an emergency fund can make a significant difference:

  • Medical Emergencies: A sudden illness or unexpected medical procedure with hefty medical bills. An emergency fund ensures that you can seek necessary healthcare without worrying about the financial burden.
  • Unemployment: Losing a job can be emotionally and financially challenging. In such a scenario, an emergency fund provides a financial buffer to cover living expenses while you search for a new job.
  • Natural Disasters: If you live in an area prone to natural disasters, an emergency fund can help with evacuation, temporary housing, and covering essential needs during emergencies.
  • Urgent Travel Needs: Family emergencies or unforeseen circumstances might require immediate travel. Having an emergency fund allows you to book tickets or arrange accommodations without delay.
  • Business Emergency Fund: If you’re an entrepreneur or business owner, unforeseen expenses, economic downturns, or operational challenges are unavoidable. An emergency can help tackle these problems and keep the business running smoothly.

Calculating The Right Size For Your Emergency Fund

Although there is no right size, as a general rule of thumb, your fund can be 3–6 months of your monthly expenses, depending on your income and costs.

People with unstable jobs, on the other hand, should set aside 6–12 months’ salary as an emergency fund.

For example, if you earn Rs. 30,000 per month and spend Rs. 15,000 on ordinary living expenditures, your emergency fund should be in the range of Rs. 60,000–1,000,000.

Now, if you’re confused about what to include in your monthly expenses, here are some essentials:

  • Rent/maintenance
  • Mortgage
  • Utility bills
  • Food
  • Transportation
  • Insurance
  • School fees
  • Staff salary
  • Grocery bills

Plus, if you spend a significant amount on subscriptions such as gym, OTT, etc; make sure to include those as well.

Where To Park Your Emergency Fund?

When choosing emergency fund options, accessibility is a key feature. So, depending on what you’re saving for, consider assets with different lock-in periods. Some options could be tax savings fixed deposits, provident funds, and government bonds, among others.

To help you make a better decision, here are some of the best options for storing your emergency fund and ensuring easy access:

  • Mutual Funds: Mutual funds are perfect for storing emergency money in the form of liquid funds or overnight funds. You can still get a good return by setting a short timeframe. Investors can select from a variety of choices based on their risk-return perceptions and investment time frame.
  • Certificates of Deposits (CDs): CDs generate a higher interest rate than other bank accounts. They differ from the other options on our list in that you must maintain your money in the account for a set amount of time in exchange for a guaranteed rate of return. When the ‘period’ of the CD expires, you can retrieve your initial cash with interest.
  • Sweeped-in Savings Accounts: Many savings accounts include a sweep-in feature, which allows you to invest excess funds in a fixed deposit. But if you ever need the cash, you can easily withdraw the amount after paying a fee, if any. Thus, your fund will yield greater returns than a simple savings account.
  • Money Market Accounts: These are interest-bearing accounts offered by banks or credit unions that function similarly to a checking account and a savings account. They are low-risk, making them excellent for an emergency fund. The funds in money market accounts can also be accessed immediately with a debit card at some banks.
  • Roth IRA: When you reach retirement age, you might want to consider putting any necessary savings into an Individual Retirement Account (IRA). For instance, if you choose a Roth IRA, you could potentially earn more than you would from a typical savings account without taking on too much risk.

How to Maintain Your Fund Responsibly?

Just creating an emergency fund isn’t enough; you need to know how to manage it responsibly too. Here are some tips you can follow to use your fund wisely:

  • Set a Goal: Calculating how much you can afford to save each month is the first step in creating an emergency fund. Examine your current budget or build one to make the process simpler. This helps you realize how much money you have left over to save after eliminating necessary expenses such as food, insurance, and power bills.
  • Automate your Contributions: To have money sent from your checking account to your savings account regularly, set up recurring transfers through your bank. You can choose the amount and frequency, but once it’s set up, the contribution remains consistent.
  • Regularly Monitor Your Progress: Whether it’s an automatic notification of your account balance or keeping a constant record of your expenditures, find a way to track your progress. It can provide immediate gratification and act as an incentive to keep going.

How to Use Your Emergency Fund Wisely?

You should use your emergency fund in situations that qualify as genuine emergencies. These are unexpected events or expenses that require immediate attention and can potentially disrupt your financial stability.

Here are some common scenarios when it’s appropriate to use your emergency fund:

  • Medical emergencies
  • Unemployment
  • Natural calamities
  • Sudden travel plans
  • Death of a family member
  • Business or legal emergencies
  • Car or home repairs

Take Control Of Your Financial Future

Having an emergency fund prevents you from falling into a debt trap, mortgaging existing assets, or liquidating future assets like retirement funds. However, the key is to refrain from using these funds for non-essential expenses, no matter how tempting it may be. Lastly, avoid investing your emergency funds in risky assets, since you might need them at a moment’s notice.