An emergency fund is a financial safety net that helps people address financial dilemmas such as unforeseen medical expenses, major repairs to their home or car, loss of job, etc.
According to most financial planners, an emergency fund must contain enough funds to cover between three to six months’ worth of expenses. You must note that financial institutions don’t carry accounts labelled as emergency funds. Rather, the onus falls on an investor to set up this type of account and designate it as capital reserved for personal financial crises.
Typically, these funds should be held in highly liquid assets such as overnight or liquid mutual funds, savings accounts, money market instruments, etc. The primary objective of these funds should not be wealth appreciation, but safety and liquidity.
Why is it important to have an emergency fund?
Having an emergency fund should be a priority for everyone if you’re planning for a financially secured life. Here’s why:
- Helps to keep your stress levels low. When you have an emergency fund, you tend to have a relaxed and stress-free life. This is because you know that you have a backup plan in place in case things go south or an emergency pops up.
- Ensures that you do not spend your future savings. Your savings are linked to some very important future goals. An emergency fund helps you to achieve your future dreams by meeting your urgent needs so that you don’t have to tap into your long-term investments.
- Ensures that you do not fall into a debt trap. During financially challenging times, emergency funds can help you stay afloat without having to rely upon loans or credit cards. Emergency funds, thus, ensure that you do not fall into a debt trap during a financial crisis
To cover unexpected expenses, emergency funds must be liquid. One should never put their emergency funds in investment options with a lock-in period as their money can get blocked. One should be able to withdraw the money when they need it without being penalised in the form of exit load or pre-withdrawal penalty. Youiu can keep a part of their emergency funds in a savings account, which can be accessed immediately, and invest the rest in highly liquid options such as overnight funds, liquid funds etc.
How much should you have in your emergency fund?
Depending upon your income and expenses, the right ‘emergency’ amount depends on your financial position. A good thumb rule states that the ideal amount for your emergency funds should be at least three to six months of your living expenses.
You can also divide your emergency funds into two categories:
- Long-term emergency funds: Under this category, you save for large-scale emergencies such as sudden medical requirements or a major natural disaster. You can consider investing these funds in instruments that allow youa to earn a slightly higher rate of interest but do not take more than a couple of days to liquidate.
- Short-term emergency funds: Short-term emergency funds cater to your immediate cash requirements. These funds might offer little in terms of interest but offer high liquidity and accessibility, which can suffice until you gain access to your long-term emergency funds.
How to calculate your ideal emergency fund
The calculation to know your ideal emergency fund amount is quite easy.
- Jot down your monthly income: Your monthly income includes your current salary, secondary income, bonus, investment income, pension (in case you are retired), and other miscellaneous income.
- Determine your monthly expenses: Your monthly expenses include rent, EMIs (auto/house/personal/educational loan, etc.), utilities, household help wages, groceries, and other miscellaneous expenses.
- Determine the monthly amount spent on recreational activities: These include dining out, shopping, movies, and miscellaneous activities.
- Evaluate the amount spent on travel It includes fuel, public transport, etc.
- Calculate the monthly amount spent on your dependents: This includes school/college fees, medical bills, family support, etc.
- Jot down other monthly expenses: This includes subscriptions (gym, etc.), gifting expenses, insurance premiums, holiday expenses, etc.
Finally, add all your monthly expenses + recreational activities + travel + amount spent on dependents + other monthly expenses and multiply them by six. You now have your calculation to set up the emergency fund.
How to build an emergency fund?
An emergency fund is not built overnight but is rather done gradually. Here are the steps you can follow to build an emergency fund:
- Calculate your monthly expenses. Try to control your expenses as much as you can so that you save enough to invest in an emergency fund.
- Calculate the total corpus you wish to save: Determine the required corpus to figure out how to add up to your living expenses of at least six months.
- Set a monthly savings goal: This will get you into the habit of saving regularly and ensure that the task of creating an emergency fund feels less daunting.
- Assess and adjust contributions. Make sure to check after a few months and evaluate how much you are saving, and adjust if you need to add more funds.
Where to invest an emergency fund?
Once you have finalised the amount for an emergency fund investment and started working towards acquiring that amount, it is important to find a good place to invest the emergency fund corpus.
A savings bank account is a logical choice as it offers high liquidity during a crisis. However, another important feature of emergency funds is that one does not need them regularly. So, rather than investing your entire corpus in a savings account, you can consider investing a part of it in investment securities that offer high liquidity as well as more significant returns than a savings account.
Overnight funds offer reasonable liquidity with the potential to earn better returns than a savings account while keeping risks minimal. Invest in a way that offers decent returns without compromising on the liquidity factor. The ideal thing to do is spread your funds across various investment options such as short-term recurring deposits (RDs), liquid funds, money market instruments, etc.
An emergency fund can make a world of difference during crises and help you stay prepared for any financial setbacks. One should view their emergency fund as an insurance policy and guard it carefully. It is not a piggy bank, so you should not use it for incidental expenses. In fact, as your salary increases and new members get added to your family, make sure to increase the amount to match your new situation. Happy Investing!
This article is contributed by our partner Franklin Templeton.
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The information in this article is not intended to be and does not constitute financial advice, investment advice, trading advice, or recommendation of any sort offered or endorsed by Autumn.