Updated: Aug 25, 2020
As individuals we all have a variety of goals and a proper planning help us to achieve them in a timely and systematic manner. One such planning is financial planning which we do to achieve our financial goals such as buying our own house, planning an early retirement, getting out of debt, sending children overseas for higher education or maintaining a well-stocked emergency fund.
Emergency fund forms an essential component of a healthy financial plan. It is an amount of money set aside to deal with sudden unforeseen circumstances, at least financially. You may need this fund to meet emergencies like: loss of job, medical emergency, major car or house repair, unexpected sudden travel expense like having to visit your children studying abroad, on a short notice, or any other such unplanned expense. By staying prepared financially, for such situations, though you cannot completely avoid the damages caused by them but you can definitely reduce their effect to a great extent. Moreover, this fund provides you with a financial buffer to help you avoid borrowing, take high-interest loans or rely on credit cards in such times of need.
In all we can see that we cannot ignore the importance of staying well prepared with emergency fund, hence it is advisable that every individual should compulsorily maintain one. But the questions arise that what is the ideal amount that should be saved as emergency fund, how can it be built and where it should be kept?
How much should be an emergency fund?
It depends on a lot of factors like the financial circumstances of an individual, the nature of work that person does and the position that person holds in the organization. The higher the position in the organization and more complex the nature of job more difficult it would be for that person to find the next employment in case of loss of job. As a good rule of thumb, financial experts suggest to maintain an amount measuring up to 3 months of your income or 6 months of your expenses, whichever is greater. That means if your monthly income is Rs. 50,000 and your monthly expenses come around to Rs. 30,000, then your emergency fund should ideally be around Rs. 1,80,000.
Over padding of the fund should be avoided since this money does not yield much return. By tying more than required money in your emergency fund you miss onto the opportunities to invest it in places yielding you a much high returns.
How to build an emergency fund?
Since an emergency fund amounts to almost six months of your expenses, it cannot be built overnight in fact it is built overtime but you need to start early even though you start small. For this you will have to:
· Set a monthly saving goal to get yourself into the habit of saving.
· Cut certain expenses which do not add any value to your other life goals. This could include: not eating out too often, recycling and reusing your clothes instead of buying new ones or using public transport or carpooling.
· Take up a part time job along with your regular job for that extra income if you have the time and will power to do so.
· Save your tax refund, in case if you get, to boost your emergency cash reserve.
Where to keep your emergency fund?
Once you have accumulated the emergency fund you might be tempted to invest it in stocks and bonds for higher returns. But, since the stock market is volatile, fluctuates frequently, is prone to high risk and is basically a long term investment venue, you might have to sell your stocks and bonds at a lower price at the time of emergency. Therefore, investing this fund in the stock market is not a very good idea. Leaving it in cash would mean, making it vulnerable to accidental spending or loss due to theft or fire. Moreover, since you are not getting any returns you are losing your money to inflation. Experts, therefore, suggest to not to keep more than ₹ 20,000 in cash at home.
According to some financial planners you should put at least 25% of the emergency fund in a savings account so that you have access to your money anytime and from anywhere. Though savings account keeps your money secure and also gives you returns, the returns are not high enough to not to let you lose your money to inflation. The best place then to keep your contingency fund would be savings account linked FD or sweep-in account where excess funds beyond a particular limit are automatically transferred to a fixed deposit to allow you to earn higher returns. When you withdraw a large sum of money the FD is automatically broken and amount gets transferred to your savings account. Some other options to keep your emergency fund are money market accounts and certificate of deposits (CDs) but they all come with their pros and cons. Therefore, a multifaceted approach is advisable, that is, parking this money in different options. While considering where to put your emergency funds, remember more than returns, easy and quick access to your money is more critical.