Building an emergency fund is like having a spare tire in your car - you never know when you might need it. A solid emergency fund can provide a financial safety net in case of contingencies such as job loss, medical emergencies or repairing that mysterious dent on your bonnet.
Without an emergency fund, these unexpected expenses can quickly spiral into debt and financial stress.
Do you have an emergency fund? How much should you keep aside? Where should you park your money? Here’s a three-step process to build your safety net.
1. Start With A Budget 👜
Budgeting is essential when it comes to building an emergency fund. It helps ensure that you are saving enough money each month
Start by listing all of your income and expenses, and classify them into mandatory, essential for living expenses, and non-essential expenses
This will help you understand your spending habits and where you can cut back in times of distress
For an emergency fund, ideally, you want to cover yourself in case you lose your job or there’s some other disruption in your life that cuts a hole in your pocket
In these tough times, it is necessary to be able to cater to expenses that are mandatory, and essential to you living your life
Discretionary expenses like going out, dining, shopping and partying can and usually do take a massive cut during tough times
In the above example, an emergency fund would need to cover EMIs and essential living expenses
If you lose your job and income, of course, you’re getting a natural break from paying taxes and provident fund contributions
💡The emergency fund needed per month will equal your mandatory expenses and essential living expenses
2. Setting A Savings Goal 🎯
It's important to have a clear idea of how much money you need to have saved for unexpected expenses.
A general rule of thumb is to have at least 3 to 12 months' worth of living expenses saved in an emergency fund.
This number will change based on a few factors:
Type of Employment
Number of dependents
% of Budget allocated towards loan repayment
How many months is a judgement call really? If you are young, have a steady job, aren’t burning your monthly income repaying loans, and don't have dependents, you should be comfortable with keeping aside enough to last you 3 months.
However, if you are older, have dependent parents who are at risk of higher medical expenses, have school-going kids, and have a home loan to pay, you are better off keeping a year’s needs aside to be safe.
For our example, at an age of 32, with no significant drags on the monthly income, and enough ability to save, a stash worth 3 months should suffice
💡The total emergency fund needed would equal your mandatory expenses and essential living expenses multiplied by the number of months you need to be covered for
3. Building The Emergency Fund 💰
Once you have your target in mind, you need to take stock of how much you already have. Sum up all the money you have:
Cash (wallet, drawers, under the sofa)
Saving account balance (across all your bank accounts)
Liquid mutual funds
Fixed deposits maturing within the next 6 months
The difference between how much you have and how much you need (Deficit) is how much you need to save up first, before splurging and investing for the long term.
In this case, a deficit of Rs. 2,19,000 needs to be made up for
This can be done either by moving some of your investment into liquid mutual funds (preferred) or channelling your savings every month into liquid mutual funds until the deficit is covered
💡When it comes to building an emergency fund, you want to make sure you're keeping it in a place that's both safe and easily accessible. For this, either Liquid Mutual Funds or Short Term Recurring Deposits work best
In Sum ➕
In conclusion, an emergency fund is an essential part of any financial plan. It provides a safety net in case of unexpected expenses and can give you peace of mind.
Building an emergency fund takes time and effort, but it's well worth it in the long run. You never know when that rainy day will come, and you don't want to be caught without an umbrella, or in this case, an emergency fund.
💡Here is an excel based calculator by Rupeeting to help you figure out how much you need to save to build your emergency fund