When it comes to financial planning, most people focus on saving for their dream home, dream car, vacations, children's education, retirement, etc., i.e. most people focus on their goals. However, they forget to save for emergencies. The COVID-19 pandemic has shown us just how quickly life can change and how important it is to be prepared for the unexpected. Many people lost their jobs or businesses, which meant they had to rely on their savings to cover their daily expenses. Without an emergency fund, this can be devastating, as it not only affects your short-term financial stability but can also set back your long-term financial goals by years. An emergency fund acts as a financial cushion, providing a source of funds that you can turn to in times of need without having to dip into your long-term savings or take on additional debt.
How much to save
It is advisable to have an amount that could cover three to six months of your expenses saved in an emergency fund. In order to determine how much to save in an emergency fund will vary as per your situation.
If you have to provide for many people who are dependent on you like your parents and children then you would have to save a higher amount in an emergency fund. In this case, you should look to save about six months of your expenses in an emergency fund. If you do not have dependents and have your spouse earning, you could have an emergency fund covering three months' expenses.
To determine the appropriate size of your emergency fund, it is important to first understand your monthly expenses. It is recommended to review your spending for at least three months to get a sense of your average monthly expenses. This should include any loan payments, such as EMIs, in addition to your regular expenses. Let's say your monthly expenses amount to Rs. 30,000 per month, you should have Rs. 90,000 at least in your emergency fund.
You should periodically review your monthly expenses and consider increasing your emergency fund if your expenses have increased.
How to save
It might appear daunting at first to save such a large amount while continuing to save for your long-term investments. The importance of an emergency fund cannot be overstated. You can start by cutting some of your discretionary expenses like reducing your expenses on dining out, substituting some products used regularly with their cheaper alternatives, etc. You should also look to direct your bonus or increment, or cash gift toward the emergency fund so that you can reach your goal at the earliest. You should also look to set up an automatic transfer so that a part of your income would be
diverted to your emergency fund. Check whether any of your funds are lying idle and can be transferred to your emergency fund.
You must always remember ‘little by little, a little becomes a lot’. Start by contributing small amounts towards your emergency fund, over time you would have saved enough. As discussed above, if you need to create an emergency fund of Rs. 90,000, you can start by contributing Rs. 1,500 each month, which would take 45 months to generate the amount. If you divert your bonuses, increments, cash gifts, etc., you would be able to reach this amount earlier.
Safeguard your emergency fund
Now that you have decided to create an emergency fund, it is important to decide where you would park the funds. It is totally possible that you might never need to touch the emergency funds. It is not ideal that the funds keep lying in your savings account without generating any return. An ideal situation would be where the funds are available to you at short notice as well as generate some return. It is important that you take into consideration the following points while parking your emergency funds:
Accessibility: As the name suggests, emergency funds are to be utilised in case of an emergency. It is, therefore, necessary that the funds are available immediately or within a short time.
Security: The funds should be parked in such a way that their value does not fluctuate. Therefore you should not invest the funds in high-risk equity funds or stocks as these instruments are highly volatile. Even though these instruments can generate higher returns over the long term, your priority with regard to the emergency fund should be security over returns
Easy to withdraw: The funds should be easy to withdraw. If the funds are parked in an investment that has a lock-in period like PPF or mutual funds having lock-in, you would not be able to access the funds when they are required.
Where to save
Now that you know that the funds should be saved in such a way that they are secure, accessible, and easy to withdraw as well as generate some return, let’s look at some options that are available.
Savings account: It is advisable to keep at least 20% of your emergency funds in a savings account. If you’re worried about using these funds for everyday expenses, you may want to open a separate account specifically for your emergency savings.
Linked Deposit: 30% of your emergency fund can be saved in a savings account linked fixed deposit. This way you can get higher interest compared to your savings account and the funds can also be easily accessed whenever needed.
Liquid Debt Funds: Remaining 50% of your emergency funds can be invested in short-term debt funds. Some options are money market funds, ultra-short term debt funds, short-term debt funds, etc. These funds will generate higher returns as well as the amount can be available within a couple of days.
To summarise, you should have at least 3 months of your expenses in an emergency fund, the emergency fund should be parked in such a way that it is accessible, secure, and easy to withdraw. You should review your expenses periodically, half-yearly, or at least annually and review whether any adjustment is required to your emergency fund.
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