What is an emergency fund and why should you maintain one? How does it benefit you and when should you start to build one? These are just some of the key questions that might come into your mind now. This post gives you an insight into what an emergency fund means and how it can really help you during a financial crunch now and in the future. Read on to know more-
What is an emergency fund?
An emergency fund popularly known as a contingency fund refers to a personal budget that you set aside for future financial mishaps or safety. It is an indispensable part of any financial planning strategy for everyone to ensure that their finances are protected and they are ready for any sort of emergencies that might occur in the future. An emergency fund will make reduce their risks of depending upon credit if such a situation occurs.
In short, you can keep debts away and use these funds for any urgent expenses like house repairs, medical costs, vehicle repairs and much more.
7 practical steps to build an emergency fund
Now, if you do not have an emergency fund yet, do not worry. It is better late than never. The following are some key simple and feasible ways by which you can build your emergency fund now-
Create a budget- This is your first step. Take a pen and paper. Make a list of all the recurring expenses you incur every month. Keep some funds aside for miscellaneous expenses that might be fixed or one time like for instance, examination fees for a test or a vacation expense. This might take a couple days for you to make, so do not rush through. Make two columns on the sheet- one for your income and one for your expenses.
Curtail costs where you can- When you make your list, you will find there are two types of expenses you generally incur every month. They are –
- Obligatory expenses
- Discretionary expenses
When it comes to determining the difference between the two, take some time. It might even take a month or two for you to figure them out correctly. You can reduce expenses where you can and save more.
Make this a regular practice- The first two steps should be carried out regularly like an exercise. In this way, you can keep aside a portion of your income every month as savings. Non-essential spending can also be filtered out gradually.
You never know how long an emergency will last so ensure you have at least three to six months of funds to cater to your needs during a financial crisis.
Let us take the following example-
Suppose the obligatory expenses of your house is around Rs 50,000 per month, so in this case, your emergency fund ideally should be around Rs 1.5 to Rs 3 lakhs at a given point of time. This amount can also change subject to the number of people that are earning in your household.
If you are a single earning member of your family with school going kids and dependent parents, you might want to consider unexpected medical expenses. If you add up two-thirds of any continuing loan, the figure you save will go up as you need to pay the instalments every month with the addition of running household expenses.
Financial experts recommend a single-income family should build an emergency fund that is bigger so that fixed expenses like house rent, instalments every month for a loan etc. can be met. This fund should be for at least one year for fixed expenses and at least six months for variable expenses of the household.
However, for double earning members of a family, the amount of funds that every earning person saves can be lower.
Set up a target date- Set a target date for your emergency fund. This will help you attain your goals faster. This date could be three months or even six months from now however, the earlier the better.
Existing assets- You might have some assets already that could be placed in your emergency fund. It could be some additional cash in your savings account or a fixed deposit you have not linked to any specific financial goals. Allocate these funds to your emergency fund.
Have a commitment- Make sure you are committed to your emergency fund every month. Determine how much your shortfall is to transfer funds for the targeted amount. For instance, if you need an emergency fund of 3 lakhs and have 1 lakh already, transfer this amount to the fund and gather 2 lakhs from other sources.
You can even split your monthly commitment. For instance, if you have a six-month target, you need to put Rs 33,000 into the fund every month. Here, you might need to be extra frugal however, in the long run, it will surely pay off.
Create a separate account for fund accumulation– Make sure you keep the emergency fund in a separate account. There will always be the temptation of taking out excess cash from your savings account and spending it.
Last but not the least, do not mix your emergency funds with your investments. They are completely different from one another. Promise yourself not to withdraw these funds unless there is an emergency. Make sure you can access the money easily when any urgency arises.
Some popular options for you to park your emergency funds are short-term deposits, cash and a savings account with a sweep in facility. Remember, your emergency fund is just like a parachute that saves you from a financial fall into a mountain of debt. Always give it the value and importance it deserves.
All the best!