An emergency saving fund is a vital component of your portfolio that helps you sail through rainy days. While the importance of an emergency fund was always there, the COVID-19 pandemic has further accentuated its significance.
While building an emergency fund, you need to consider certain aspects, and this article will help you understand its various nuances.
So, what is an emergency fund? As the name suggests, it’s a fund that you set aside for a contingency coming your way. With the help of an emergency fund, you can address unplanned expenses coming your way without needing to dip into your savings. With an emergency fund, you can manage unanticipated expenses with minimum fuss.
For instance, if your monthly expenses are Rs. 50,000, you must have at least Rs. 3 lakhs as an emergency fund. You should use this money for addressing costs that you haven’t accounted for. For example, if there’s a medical crisis in your family, you can use this money to tackle the same.
So, why is an emergency fund important? It’s essential:
An emergency often arrives unannounced and can catch you off guard. It can derail your financial plan in no time. However, things are different with an emergency fund in place. With this corpus in place, you are better equipped to deal with the situation.
Without an emergency corpus, you can mount unnecessary debt that can further strain your finances. You might end up borrowing at a high-interest rate, which could hurt your long-term goals. With an emergency saving plan, you don’t need to worry about the paucity of funds.
This is another reason why an emergency fund is important. It gives you peace of mind as you know you have the financial backup to meet unexpected expenses coming your way and are on a solid financial footing in the event of a contingency.
Now that you know the importance of an emergency fund, the next question arises - Where do you need to keep it? An essential consideration while parking money for a contingency is the ease of accessing the money. In a nutshell, you should be able to access money on short notice. Therefore, you should choose instruments that are highly liquid and can easily be converted into cash.
At the same time, you must ensure that the principal amount remains safe. This is where liquid funds can be a prudent choice as they offer easy access to funds when needed. Liquid funds invest in money market instruments with a maturity of 91 days and offer higher returns than a bank’s savings account.
Upon redeeming, the money is credited to your bank account the next day. Some fund houses also offer instant redemption where the money is credited immediately. Check if your chosen fund has this facility or not.
You can either set up a systematic investment plan in liquid funds or invest a lump sum. Apart from liquid funds, you can also choose to invest in stocks via a Trading and Demat account to build emergency funds. However, note that stocks can be a tricker bet than liquid funds as their performance is affected by market movements. So, it’s advisable to opt for blue-chip stocks that have strong fundamentals to better weather volatility.
This is a vital aspect to consider. While earlier, it was advisable to have at least six months’ expenses as an emergency corpus, COVID-19 has shown that it may not be enough. A bigger corpus gives you more breathing space should the contingency continue for long. Therefore, it’s advisable to have at least a year’s expense as an emergency corpus.
So, for example, if your monthly expenses are Rs. 50,000, then you must at least have Rs. 6 lakh as an emergency corpus. You can split this amount by keeping a portion of the same in a bank savings account and the rest in a liquid fund.
While building an emergency corpus is relatively easy, you can’t do it overnight. You need dedicated and disciplined efforts to do. To build an emergency fund, you can:
You can start building an emergency fund by making small contributions. This will ensure that you don’t strain your finances and also continue building this all-essential fund. Fix an amount that you wish to contribute towards this fund. This could be weekly, fortnightly, or monthly. Whatever amount you fix, make sure to save the same without fail.
Another way to build emergency funds is to automate your savings. A good way to do so is through systematic investment plans (SIPs) in mutual funds.
SIPs are a kind of forced savings where a fixed sum of money is deducted from your account and invested in your chosen fund on a specific date. They instill a disciplined savings habit and also beef up your corpus with time.
If you have received a bonus, income tax refund(s), and so on, it’s advisable to direct a portion of such windfall towards building an emergency corpus. Doing so regularly can help you beef up your emergency fund and replenish the same at the earliest.
Long-term emergency fund is where you save up large-scale emergencies such as a medical contingency. You can contemplate investing in instruments such as liquid funds to build a long-term emergency corpus. As said, liquid funds offer better returns than most fixed return instruments and can be redeemed easily.
A short-term emergency fund helps you suffice till the point you gain access to your long-term funds. You can park money as a short-term emergency fund in instruments such as a recurring deposit that offers comparatively lesser returns than liquid funds.
So, when should you ideally use an emergency fund? The answer is in the question itself. You must use the fund during an emergency and shouldn’t divert it for any other purpose. Doing so leaves you and your finances in a vulnerable state. Equally essential is to ensure that you replenish the corpus on time and review it at periodic intervals.
Now that you know the need and the importance of an emergency fund, make sure to build it at the earliest without fail. Take into account all your expenses and start right away. Also, ensure to keep your family members in the loop so that they can access it if you are not able to.
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