You must have an emergency fund to deal with emergencies. You can use it to cover unexpected or unplanned situations, but not for your regular expenses. Also, you must make sure that you have enough money to cover any unexpected financial needs.
Today's guide has a lot to explain about emergency funds' purpose, importance, techniques to build them, and most importantly, keep them safe!
Keep reading to know in-depth.
Did You Know?
Typically, emergency funds must have 3-6 months’ worth of payment. However, the economic crisis of 2020 due to lockdown has led experts to recommend saving the emergency funds for up to a year.
What is an Emergency Fund?
An emergency fund should be a fund that helps you continue your life and meets your essential expenses. It doesn't require you to take out unplanned loans or overuse your credit card.
You may have to include obligatory expenses in your emergency fund. These are the absolutely essential expenses.
In an ideal world, mandatory expenses would include food, medical treatment, rent and monthly instalments of loans. School fees and basic repairs and maintenance are also included. Insurance premiums can also be included if necessary. Rather than being limited to medical emergencies, the term "emergency" is used to describe a wide range of situations. Any deviation from one's normal routine that necessitates a large out-of-pocket expense not planned for in one's daily budget qualifies as an emergency. This could be major car repairs, a sudden change of employment, or even unemployment. It is critical to establish an emergency reserve that can also serve as a rainy-day fund.
Importance of an Emergency Fund
- Creating an emergency fund is essential to keep money set aside for unexpected expenses.
- Having an emergency fund can be a huge peace of mind in need. Here are a few reasons why.
- You can draw from this fund during emergencies, but it must be available when needed.
- You can save money in an account specifically designated for this purpose and invest it to earn interest.
- It can also help you avoid debt and keep your financial goals in sight.
Benefits of Emergency Funds
Now that you know what is an emergency fund, these are the benefits of having an emergency fund:
- Encourage saving behaviour: It motivates people to save money and lessens the temptation to spend their money on frivolous items such as televisions or video game consoles.
- Reduces stress levels: Some events can lead to stress, whether car trouble, sudden job loss, or home repair. Individuals take on significant risks without any cushion to protect themselves from possible events. This can harm their daily lives. However, an emergency fund gives people confidence and allows them to be prepared for unexpected events.
- Avoids bad debt: Individuals wouldn't have to consider bad debt, such as high-interest credit cards, to cover their expenses if they had an emergency fund. This type of debt can result in higher interest rates, fees and penalties if used irresponsibly.
What Amount of Money do You Require to Start an Emergency Fund?
An emergency can take many forms, from a minor one like a breakdown of your car to a major one like the loss or resignation of a job. These situations may last for several months. In this situation, you will need to manage household expenses and continue to pay your liabilities such as credit card fees or EMIs.
How much money do you need to create an emergency fund? The amount you need depends on your income and life situation. You may need a smaller emergency fund if you have more than one income stream. Single-income households should focus on building a larger emergency fund.
As you build your emergency fund, keep in mind that you should consider all possible sources of income to provide for unexpected expenses. If you lose your job, you may have to apply for unemployment or insurance benefits. A larger emergency fund can help you survive a difficult period, and it is a good idea to have one for emergencies.
It is a good idea to save multiples of your monthly expenses. At a minimum, you should have an emergency fund that covers 5- 6 months of your monthly expenses. This can be extended to 10-12 months. This will make sure that your goals are met in an emergency.
Let's say that the monthly household expenses amount to ₹50,000. Your emergency fund should contain anywhere from ₹2.5 lakh to ₹4 lakh at any one time. This can change depending on how many people are earning in your household, how many dependents you have, and your expenses.
Importance of Liquid Emergency Fund
It’s time to know the importance after knowing what is an emergency fund. Everybody should have a liquid backup fund to handle sudden needs in life. Having an emergency fund in a liquid state can prevent you from falling into debt when unexpected things happen.
In addition to providing liquidity, liquid funds have many other benefits. When it comes to preventing debt, liquid funds are essential to your financial future. It is better to have more than enough money to cover your monthly expenses, but there are certain guidelines you should follow.
Keep in mind that an emergency fund should be used for real emergencies. In case of unemployment, the fund should be earmarked to cover living expenses. You should use the money for unexpected car or home repairs, medical expenses, or even unexpected tax bills.
These are all reasons to have liquid backup funds. Having a liquid fund will give you peace of mind and allow you to take some time to rebuild your financial condition. You can open a money market fund at a credit union or bank. This type of fund is safe and can earn extra interest.
How to Build an Emergency Fund?
Budgeting is an essential part of financial planning. These are the three most important steps to follow if you're just beginning to create an emergency fund.
- Keep track of your monthly household costs and classify them as obligatory or discretionary.
- This exercise can also help you keep track of your spending and eliminate non-essential ones.
- Do it for a few months in order to identify an average target for your mandatory expenses.
It is impossible to predict the length of an emergency, so it is ideal to have an emergency fund which can help you continue for at least 3 to 4 months. You might be able to save more if you have a single-earning family member and dependent children.
If you add in two-thirds of the loans that you’ll be continuing, the savings figure will increase. You would also have to pay every month's instalments and run your household.
This is often used to cover fixed expenses such as rent and monthly instalments for 12 months. Variable expenses should be accounted for at least six months. If there are two-earning members of the same family, the savings per person may be lower.
Where Should the Emergency Funds be Kept?
Depending on your circumstances, where you place your emergency fund will be important. This fund should be accessible and safe so that you don't feel tempted to use it for non-emergencies.
These are some options to save your emergency funds. You can choose the one that is most appropriate for you.
- Credit union/bank account: An account with a bank/credit union is generally considered one of the most secure places to deposit your money. It might make sense to open a separate account to keep these funds safe.
- Prepaid card: A prepaid card allows you to load money onto it. You can only spend what you have on the card, and it is not linked to a bank or credit union.
- Liquid funds: Invest it in such a way that you get a good return without sacrificing liquidity. Spreading the emergency fund across liquid funds, short-term RDs, and debt mutual funds are the best option.
When Should It Be Used?
You should have some guidelines about emergency and unplanned expenses. While not every unexpected expense will be a major emergency, keeping your expectations in check is important.
Even if you don't need to go to the emergency room, you may need to pay for medical bills that weren't covered by your insurance. A reserve fund can be used to cover unexpected financial events. It may help you avoid falling for other credit or loans that could become debt.
Your one-time emergency expenses may increase if you take out a loan or use credit cards. However, don't be afraid to use it when you really need it. You can always rebuild your emergency savings by spending less than you have. This will be easier if you practice your savings skills over time.
If you live within your means, you might want to consider selling some of your unwanted items. Selling items online or hosting garage sales can generate money that you can stash in your emergency fund.
If you cannot earn much income from these methods, you may want to consider taking on a side job. A side job aligned with your schedule and skills can help you earn money.
Automate your transfers to your emergency fund to make it easier to remember contributing to it. Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.