/How to build an emergency fund: A step-by-step guide

How to build an emergency fund: A step-by-step guide

By Prateek Mehta

We all hope to get out of the health crisis soon, but it is unclear how the economy would fare in the next few months. It has a direct impact on our jobs and finances. Those who have been squirreling away for such a rainy day may be able to sleep a little better at night. 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.

What is an emergency fund?
An emergency or contingency fund, as the name suggests, helps you and your family to financially face a medical scare, 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.

It is, perhaps, the first ‘adult’ financial decision of any well-rounded financial plan that ensures your basic lifestyle is not affected, and you can remain afloat without having to resort to additional debt, either through credit cards, high interest loans or mortgaged assets. It helps you to avoid taking an additional financial burden, without the clarity of how you would pay it back.

How big should it be?
The size of the fund would depend on several factors such as your income, lifestyle, and number of dependents, existing debt, and so on. The general rule of thumb is to have anywhere between three to six months’ worth of essential household expenses. If you are a family with kids and only one earning member, the amount should ideally cover your expenses for 12 months.

The first thing to do is figure out what constitutes ‘essential’ expenditure and what part of your income goes towards it. Your essential expenses are basically expenses that are required for day-to-day functioning. These would include:

Fixed expenses: Rent/ maintenance, mortgage payment, insurance premiums, other loans (car/ education), school fees, salary for staff (house help/ driver), etc. Do OTT subscriptions such as Netflix make the cut as essentials? Maybe yes, maybe not. Include all such expenses that you consider essential when arriving at a number.

Variable expenses: Grocery, medicines, electricity, gas, travel, phones bills, internet, and other incidentals.

It goes without saying that frugality is the key to surviving an emergency. Hence, spending on clothing, dining out, subscription to a gym, etc. are usually left out of the gamut of an emergency corpus.

To simply put it in numbers, say, for example, your monthly living expenses amount to Rs 40,000. Your emergency fund should be anything between Rs 1.2 lakh to Rs 2.4 lakh or even more, depending on what you feel comfortable with. Remember, this number really depends on your family situation. An emergency fund of a young and single earner will look a lot different from that of a single income family with two school-going children.

How to build an emergency fund?
Putting aside a couple of lakhs may seem like a gargantuan 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:

  1. 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.
  2. Use a separate account: This should be parked with the principle of out of sight, out of mind – this way you are unlikely to get tempted to spend that money. Ideally, park the money in short term debt funds known as liquid mutual funds. More on that later.
  3. Pay your future self first: Just as you strategize for other financial goals such as planning for retirement or saving up for a home, put aside a small amount every month as soon as you receive your salary/ draw your business income. If possible, automate the transfer so that your savings are taken care of on a priority.
  4. Trim your expenses: Reigning in on the non-essential expenses mentioned earlier will allow you to get to your saving goals quicker, and maybe even increase the monthly allocation. You don’t have to go absolutely cold turkey, but just prioritize your expenses. Instead of eating out on a weekly basis, cut it down to one or two outings a month, watch movies at home, limit non-discretionary online shopping, etc.
  5. Reallocate lumpsum receivables: Have you received a bonus at work, got a tax refund, or an envelope from an aunt on your birthday? Set aside a small amount to enjoy yourself, and allocate the rest to your emergency fund. Adding any windfall gains can really help fast-track your goals.

How to manage an emergency fund?
Just saving up some money is not enough. Just as you strategize to save for the goal, you need to have a plan for its deployment and use.

There are three crucial aspects to look at when deploying an emergency fund: security, accessibility, and liquidity.

Security: The money in this fund is to help you through a tough situation; hence, you cannot deploy it anywhere where there is 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 emergencies strike fast. If you do not have timely access to your emergency fund, it is pointless. Ensure that the funds are conveniently accessible so that you can take care of immediate expenses.

Liquidity: Liquidity refers to how quickly your investments can be converted to cash. Long-term deposits, bonds, Provident Fund (PF), National Savings Certificate (NSC), etc. do not work as they are either irredeemable before maturity or have an upper limit on withdrawals.

Keeping these factors in mind, you can try the 15:15:70 method for deploying your emergency fund.

Cash: Keep 15% of the money in liquid cash. Keeping too much cash is not recommended from a safety point of view. Additionally, over a period of time, idle cash loses its value due to inflation and rising cost of living.

Bank deposits: Another 15% could be held in your bank account securely. It takes away the risk of spending the money and the funds will earn a small interest on the savings bank account.

Cumulatively, this 30% of your emergency fund, provides quick access for immediate use and for smaller emergencies.

Investment: The balance 70% of the fund can be invested either in short-term deposits or liquid mutual funds. Both these debt instruments have minimal risk, and they 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 back into your account within a day or two.

Liquid mutual funds have a small advantage over bank deposits. The entry barrier for liquid funds is low. You don’t need to save a minimum sum to get started in it unlike a fixed deposit. Most banks would need close to 10,000 to get started with an FD. Additionally, these funds tend to offer higher returns than standard bank deposits, allowing you to at least match inflation if not beat it. Lastly, your bank may levy a premature withdrawal penalty on the deposit, but there is no such cost associated with liquid funds.

To sum up, an emergency fund can make a world of difference in times of a crisis and prepares you against financial setbacks. Remember, like any other financial goal, your need for an emergency fund is going to be dynamic. Which means if you add a family member, or upgrade your lifestyle, your emergency funds need to reflect the proportionate change in expenses. Finally, use the money judiciously – only when you really need it.

(Prateek Mehta is co-founder of Scripbox, a mutual fund fintech firm.)

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