Having an emergency fund is a necessity in everybody’s life. Consider it as a safeguard for the bumps of life, one that will hold you back from adding to the heap of debt you most likely already carry. The coronavirus outbreak has shown a giant spotlight on the difference an emergency fund makes when a crisis hits. It is like life insurance and gives you a better shot at weathering a crisis without running up a credit card balance or bearing a personal loan.
An emergency or contingency fund, as the name sproposes, helps you and your family to monetarily confront a medical alarm, unavoidable household repairs, sudden loss of job or salary or pay cut or something that impacts the community at large such as wars, social unrest or a pandemic like the current one. A small financial cushion helps one immensely to tide over tough times. It also assures peace of mind. If you already do not have an emergency fund, this is an opportune time to create one.
How to build an emergency fund
Putting aside a couple of lakhs may seem like a huge task, but with a little planning, financial prudence and a step-by-step approach, you can easily get there. Here are some quick tips on how to get the ball rolling.
- Set a monthly goal: Once you decide the amount that works best for you, stagger your goal into smaller palatable monthly deposits. This puts you into the habit of saving and makes the task a lot less daunting.
- Use a different account: This ought to be considered with the principle of out of sight, out of mind. This way, you will probably not get tempted to spend that money. Ideally, park the money in short-term debt funds known as liquid mutual funds.
- Pay your future self first: Just as you plan for other monetary objectives, for example, getting ready for retirement or putting something aside for a home, set aside a small amount every month when you get your salary or draw your business income. You can automate the transfer so your saving funds are dealt with on a priority.
- Trim your expenses: If you can control your costs on the non-essential things, then you will be able to get to your saving objectives quicker and perhaps increase the monthly allocation. You need to focus on your expenses. Rather than eating out on a weekly basis, slice it down to a couple of trips a month, watch films at home, limit non-essential online shopping and so on.
- Reallocate lump sum receivables: Sometimes you might have received a bonus at work, got tax refund or gift cash. You can put aside a small amount to enjoy yourself and designate the rest to your emergency fund. Adding any bonus gains can truly help fast track your objectives.
How to manage an emergency fund
Simply setting aside up some cash isn’t sufficient. Just as you plan to put something aside for the goal, you need to have a plan for its deployment and use.
There are three critical angles to see while deploying an emergency fund:
- Security: The money in this fund is to help you through a tough situation, thus you can’t deploy it anywhere where there is a risk of capital erosion in the short term. Equity/equity-based mutual funds or any other option with a proportionately high risk should be avoided.
- Accessibility: Most crises strike fast and if you don’t have timely access to your emergency fund, then it is pointless. Ensure that the funds are conveniently available so you can deal with immediate expenses.
- Liquidity: Liquidity refers to how rapidly your investments can be converted to cash. Long-term deposits, bonds, Provident Fund (PF), National Savings Certificate (NSC), etc. don’t fill in as they are either irredeemable before maturity or have an upper limit on withdrawals.
Keeping these components in mind, you can attempt the 15:15:70 method for deploying your emergency fund:
- Cash: Keep 15% of the money in liquid cash. Keeping an excess of money isn’t suggested from a security point of view. Furthermore, inactive money kept for a long time loses its value due to inflation and the rising cost of living
- Bank deposits: Another 15% could be held in your bank account safely. It removes the risk of spending the money and the funds will acquire little interest on the savings bank account.
- Investment: The balance 70% of the fund can be put either in short-term deposits or liquid mutual funds debt instruments that have minimal risk and are highly liquid, too. Your investments can be liquidated through the fund house or bank’s app or a physical request, and the funds will reflect into your account within a day or two.
To summarize, an emergency fund can improve things significantly amid an emergency and prepares you against monetary difficulties. Like other financial goals, your requirement for an emergency fund will be dynamic which implies if you add a family member or upgrade your lifestyle, then your emergency funds need to reflect the proportionate change in expenses. Also, you should remember to utilise the money judiciously and when you truly need it.
Frequently Asked Questions
- How many months should a person have set aside in a savings plan for emergency funds?
Most experts recommend keeping three to six months’ worth of expenses in an emergency fund, but some situations warrant more. Some experts recommend a smaller emergency fund while you’re paying off debt. If your job is secure and you don’t have a lot of expenses, then you may be able to save less.
- What is a good emergency fund?
Most experts believe that you should have enough money in your emergency fund to cover at least 3 to 6 months’ worth of living expenses.
3. Should I use my emergency fund to pay off debt?
While you should always make at least the minimum payment on all debts, it’s more important to start an emergency fund than it is to pay extra toward good debt like your mortgage or student loans.
Tax benefits are as per the Income Tax Act, 1961, and are subject to any amendments made thereto from time to time
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