How to build an emergency fund? – Advisor Forbes INDIA
If there’s one thing the ongoing coronavirus pandemic has taught us, it’s that an emergency can strike at any time and there’s nothing you can do about it but be prepared. While an emergency such as a natural disaster such as earthquakes, floods, a health condition that prevents you from working, an economic downturn resulting in job losses and wage cuts, may not be under your control, but making sure you have enough funds to get by is in your control.
How do you lead your life and meet your essential expenses in times like these? The answer lies in building up an emergency fund that could help you navigate.
What is an emergency fund?
An emergency fund is a fund that should help you get on with living and meeting your mandatory expenses without taking out unexpected last-minute loans, overusing your credit card, or selling and mortgaging your existing assets.
For your emergency fund, you may need to consider mandatory expenses which are absolutely necessary expenses.
Ideally, mandatory expenses include food and medical expenses, rent, monthly loan payments, school fees, basic repairs and maintenance, insurance premiums, and anything else you deem essential.
However, there is no standard definition of what qualifies as mandatory. For example, providing support staff like domestic help and drivers may be mandatory for some, many may find a gym membership impossible to give up even in times of financial hardship. The bottom line is that you must set aside enough funds to meet your mandatory expenses.
How to save for an emergency fund?
Budgeting is the cornerstone of all financial planning. If you are just starting to build an emergency fund, there are three main steps you should take.
- Record your monthly household expenses and categorize them into mandatory and discretionary expenses.
- Do this for a few months to get an average figure of your mandatory expenses.
- Completing this exercise could also help you take stock of your expenses and filter out non-essential expenses.
You can never predict how long an emergency situation may prevail, so it is ideal to build up an emergency fund that could keep you going for at least 3-6 months.
Suppose your mandatory household expenses are INR 50,000 per month. In this case, your emergency fund should contain between INR 1.5 lakh and INR 3 lakh at all times. This could change depending on the number of earners in your household, the number of dependents, and your expenses.
If you are a single-income member with dependent parents and school-going children, you may want to save more by factoring in unforeseen medical expenses. If you add two-thirds of the outstanding loans, the savings figure would increase because you will have to pay your monthly payments in addition to managing your household.
Personal finance experts advise single-income families to build a larger emergency fund, often to cover fixed expenses (rent, monthly payments) for a year and account for variable expenses for at least six months.
In the case of a family member with dual income, the amount of savings per person could be lower.
How to build your emergency fund?
The amount of money needed to save for your emergency fund can make you nervous and cause you to put aside your business start-up plans. Before you give up, use simple strategies so you can build up the required financial corpus without worrying too much.
Set a target date for building your fund
Setting a target date can help you reach your goal faster. Based on your current financial situation, set a date to reach your goal for the emergency fund. It could be three months, six months or even a year. The earlier you start, the easier it is to raise the necessary funds.
Take stock of existing assets
You may already have a certain amount of assets that could be funneled into your emergency fund. It can be extra money lying around in your savings accounts, fixed deposits that are not tied to any particular goal, among others. You can allocate part of this amount to your emergency fund.
Establish a monthly commitment
Based on your shortfall figure, which refers to the amount by which your needs exceed the funds you have available, establish a monthly commitment to your fund.
For example, if your total fund requirement is INR 3 lakh and you have an existing fixed deposit of INR 1 lakh, you can withdraw INR 1 lakh from your existing savings and collect an additional INR 2 lakh.
A simple way to gather the figure is to divide it into a monthly commitment. If you have set a 6 month goal, you will need to set aside INR 33,000 every month. Until you reach your goal, you may have to be very frugal, but the variety will be worth it in the long run.
Create a separate account for accumulation
There’s always a temptation to spend when there’s extra money lying around in your savings account. Instead, you can place this extra money unrelated to one of your goals in a separate account set up to accumulate capital for your emergency fund. You can do this simply by:
- By promising not to withdraw any amount from this fund until you have reached your goal.
- Set up an automatic debit function on the account where you receive your salary to ensure that you meet your monthly commitment to the emergency fund.
- Schedule the date of this transfer as close to your income credit date as possible so that you don’t have the option of spending this amount on other discretionary expenses.
Channel any lump sum contributions to your emergency fund
Set aside any lump sum inflows like bonuses, income tax refunds, or credit gifts you receive, to achieve your goal of building an emergency fund sooner rather than later.
How to secure your emergency fund?
You have accumulated the amount required for your emergency fund; what you do now? Would it be ideal to let your funds sit in your savings account with a paltry 3% to 4% monthly savings return and watch inflation erode the value of your money? Remember that you may never use your emergency fund.
Here, it is important to understand that these funds are part of your hard-earned money and should generate returns, regardless of the purpose for which they are intended. Just as it’s important to save money for emergencies, it’s equally important to park them in avenues that allow you to access those funds when you need them.
There are some things you should always keep in mind when parking your emergency funds.
- Safety and security. The safety of your funds is of utmost importance as emergency funds are meant to help you through difficult times. You can’t be careless and park them in high-risk investments like stock market-linked stocks, futures, and options, or in unorganized avenues like chit funds. Although the returns in these categories are high, the risks of losing your capital are just as high.
- Ability to access money at any timee. Many emergencies may not give you enough time to react and make arrangements to get money. It is therefore imperative that you invest your funds in accessible ways without requiring complicated withdrawal processes. For example, many Indians hold gold in the form of coins or jewelry with the intention of using it in an emergency. But selling or pawning your gold in an emergency can be tedious.
- Easier to remove. There are many safe investment opportunities, such as the low-risk public provident fund, long-term or fixed-rate term deposits, national savings certificates or recurring deposits. But these types of investments come with a fixed tenure, penalties and other conditions attached in case of premature withdrawal in case of emergency. So investing your emergency funds in these avenues may not serve the purpose.
- Don’t confuse investing with emergency funds. It is necessary to maintain a clear distinction between funds intended for investment and funds intended for emergency use so that the decision on the location of these funds is easier.
- Think about taxation. When you invest funds in various investment avenues, you may be taxed on the gains. So choose avenues where you can balance the tax implications.
Where do you park your emergency funds?
Some of the options available to you are:
Cash: Nothing like cash to deal with emergencies. But this may not be the ideal route given the security concerns as well as the zero return on a substantial amount of available capital.
Savings account with redemption option: Many savings accounts allow you to have a swipe service where amounts over a set limit are funneled into a fixed deposit. But if you ever need money, nothing prevents you from withdrawing any amount after paying penalties, if any. This way, your fund will gain something more than a savings account.
Short-term fixed deposits: If you are worried about spending the money saved in a savings account, you can open short-term fixed deposits with your bank. When choosing this option, it would be helpful to understand the terms and conditions before opening a deposit account.
Liquid Mutual Funds: Liquid UCITS fall into the category of debt UCITS. These funds invest in short-term fixed income securities such as certificates of deposit, term notes, among others. Liquid funds offer a slightly higher return than fixed deposits and are more liquid. The low minimum investment criteria are another positive factor.
It is important to know that liquid mutual funds carry an exit charge when redeemed before seven days and are subject to short-term capital gains to your income tax bracket when redeemed before three years. The redemption amount may take up to a day or two to be deposited into your account.
Considering the fact that each of these investment avenues behaves differently, it might be a good idea to divide your emergency funds between them based on your comfort level. You can consider splitting your fund in a ratio of 20:20:60 or 20:30:50 between cash, savings with sweeping ease, and short-term deposits or liquid mutual funds so that your emergency fund remains accessible as well as gains returns.
An emergency fund is like your parachute that keeps you from free-falling in the event of a financial crisis. So always give it the importance it deserves.
It would be helpful to keep reviewing your emergency fund needs at least once a year, as there may be changes in your life, such as starting a business, taking a sabbatical, adding a new family member or a change in your lifestyle.