Just like financial markets, life is unpredictable. It is full of ups and downs. You can not predict what curve-ball life is going to throw at you tomorrow. How this sudden unexpected event will affect you depends on how well prepared you are to handle this financially.
An emergency fund is instantly accessible cash set aside by you for the sole purpose of facing these nasty surprises. In other words, emergency funds act like armour you can wear in order to battle unpredictable moments. In testing times, everything will depend on the strength of your armour.
Below are some examples of what constitute these emergencies:
- Loss of job or income source
What if your entire team gets laid off tomorrow? It takes time to find a new job or an income source.
- Medical Emergencies in family
What if your health cover doesn’t provide cashless services? Or the cover is not enough for expensive procedures?
- Other Emergencies
Theft or breakdown of your car or urgent repair of a leaky roof. Or a sudden expensive trip you have to undertake due to an emergency in the family.
Why an Emergency Fund is important
Emergency funds, rainy day funds, contingency funds, savings cushion or buffer funds, whatever you may like to call them, play a very vital role in building your healthy financial life. Here is why:
- Debt Control
The first rule of getting out of debt is to not go further into it. The most important reason for the creation of a contingency fund is that it prevents you from getting entangled in a debt trap. If a major repair on your car is not covered under your car insurance, your credit card may seem like an easy option at the time. But if you don’t pay off the amount in full before the due date its high rate of interest will take a toll on your financial future.
- Financial Goals/Investment protection
When your contingency fund is in place, it means that you will not have to cover your emergencies from your goal-based long term investments. In other words, an emergency fund makes sure that emergencies are taken care of without taking a chunk out of the money you were investing for your child’s education. Moreover, since most long-term investments are parked in the high-risk high-return category, you might take a huge hit if you withdraw your investment on a particularly bad day at the financial markets. Also, investments from mutual funds are not instantly accessible – you might have to file paperwork and wait for a few days depending on the fund house.
What should be your Emergency Fund amount?
There are many conflicting views on this. Some say 3 months of living expenses is good enough for a contingency fund. Others say at least 6 months of expenses should be covered. Finally, some experts say 9 to 12 months of expenses should be in an emergency fund.
The reason for so many different opinions is that one size doesn’t fit all. How much money one needs in a contingency will depend on one’s financial situation.
Generally, six months of expenses are taken as a rule of thumb for the amount required as an emergency fund. This is because it is believed that in this duration people can find another source of income.
You don’t want to park too much money in a contingency fund because the more passive your money is, the less you earn on it, like in a savings bank account.
But still, consider your situation and decide what amount will make you feel comfortable.
How to create an Emergency Fund
- Find out your monthly expenses and multiply the amount with the number of months you want to cover. The total is your targeted contingency fund amount.
- Now, based on your budget, find out how much you can set aside regularly for the creation of an emergency fund. Give priority to it. Start with small contributions if you must, but start nonetheless.
- Park the designated amount in a safe and liquid place. This is because you don’t know when you might need these funds. So quick availability should be the deciding factor. Also, since you are aiming for a fixed amount you can’t afford volatility, so investing in equity should not be your choice. You can place the contingency fund amount in a savings bank account (3-4% returns per annum), or fixed deposits (6-7%). Remember that growth is not on the table, a contingency fund safeguards your actual investments it is not an investment in itself.
- Remember to replenish the amount you used in a contingency.
- Lastly, use this money only in case of emergencies and emergencies only. Don’t try to cover your needs (should be taken care of in budget) or wants (set financial goals) with this fund. To inculcate discipline open a new bank account just for the emergency fund.