With the recent pandemic, everybody realized the importance of an emergency fund. During this period, many people lost their jobs, got salary cuts, got sick, and understood the importance of having one. Those who saved something for extreme situations got sailed through, and others got affected very badly.
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What is an emergency fund?
The emergency fund is a stash of cash that you set aside to use in situations like medical emergencies, economic crises (job layoffs, salary cuts), and natural disasters (floods, earthquakes, cyclones, etc.).
In situations like these, you may need money for food, health, house repairs, family support, and many other things. That’s why it is critical to put aside some money for extreme situations.
It is like a safety net that protects you from any unexpected situations.
How much money do you need in the emergency fund?
The emergency fund size varies from person to person because each has a different household income and needs.
The general rule of thumb is to have at least 3 to 6 months of your essential monthly expenses as your emergency fund.
To be on the safer side, you can have your nine months essential expenses as your emergency fund.
Essential expenses are the amount of money you spend every month on mortgage payments, utility bills, children’s fees, medical expenses, and anything you consider important.
This money can be used to cover your monthly needs for a while when you don’t have a job, got laid off, can’t able to work because of an accident, or when you quit your job.
To find your essential expenses, you need to do budgeting for a few months, track how much money you spend on everything, and sort out essential expenses from non-essential ones.
The essential expenses include your mortgage payment, utility bills, children’s school fees, food, medical bills, etc.
Non-essential expenses include Entertainment (E.g., Netflix), eating out, buying new things, gifts, etc.
How to build an emergency fund?
You can build an emergency fund by following the steps below
Set a goal
You need first to decide how much money you want. If you wish to have six months of monthly expenses as an emergency fund, multiply six * essential expenses. Suppose you want to have nine months of expenses as your emergency fund multiply nine * essential expenses.
Adding lumpsum money
You will already have some extra money in your savings account or any other savings without any particular goal. Add that money to the emergency fund.
Add your bonuses and any other extra incentive that you receive from your job.
You need to set aside a certain amount of money every month for your emergency fund.
How much money you need to set aside depends upon how fast you need to reach your goal.
For example, you already added some extra money you had to your goal. Now divide the new goal(old goal – extra cash) by how many months you need to reach your goal.
(Goal – extra cash) / months
If you want to reach your goal in 6 months, divide your goal money by six, or if you’re going to reach your goal in a year, divide your goal money by 12, and likewise.
Create a separate account
Creating a separate account will make your life easier, and you are less likely to spend your emergency fund before it’s needed.
When you save your emergency fund in a regular savings account, which you use for everything, you will accidentally spend your emergency fund money on unnecessary things.
Most of us will get tempted when we see a large amount of money lying around in our bank account.
That’s why it is recommended to use a separate bank account for an emergency fund.
You can add more money to the goal by cutting expenses. When you did budget to find your essential expenses, you would have found some non-essential expenses cut down your non-essential expenses, and add that money to your emergency fund.
Try to be frugal until you reach your goal. The next time you buy a new car, new clothes, or other things, try to buy less expensive items.
An easy way to add more money to your emergency fund is by making some. There are some simple side hustles that you can do online, like taking surveys to make some extra cash.
How to protect your emergency fund?
The primary purpose of your emergency fund is to help you when in need, but what if you can’t access your money or you lost some of your money. It will be a headache, and you will feel very frustrated. That’s why it is crucial to keep your money in a safe place and where you can access it easily.
Since this is an emergency fund, there is a good chance that you may never access it, so you can’t let the money lose its value to inflation. That is why you need to invest this money in a way that meets all of the criteria.
Safety should be your highest priority when it comes to emergency funds. Since you will need this money at urgent times, you can’t risk losing your money to get high returns, like investing your emergency fund in high-risk stocks or mutual funds. Keep your money in a safe place, and don’t go for high-risk, high-reward investing options.
In an emergency, you need money very quickly, and you have to react very fast. That’s why it is important to have your money in a place that is very easily accessible.
Don’t mix up
Don’t mix up your emergency fund with anything else. Keep your savings or investing money separately from your emergency fund.
When you invest your money, you will get capital gains and get taxed for your capital gains. That’s why it is crucial to choose an investment option that has fewer tax implications.
Where should you keep your emergency fund?
The most frequent question everybody asks themselves is, where should I keep all of my money?
To start off, you should keep your emergency fund in a place where you can access it swiftly.
The standard options are cash, savings account, liquid mutual funds, and short-term bank fixed deposits. Since this is an emergency fund, it should be available when you need it.
It shouldn’t be kept in a very difficult place to access like long-term bank fixed deposits or high-risk places like stock market equities or equity mutual funds where there is a good chance of you losing your money.
When it comes to an emergency, cash is king. It is the immediate response you can have for most situations.
But is it wise to keep cash in your house? i
The answer is no because you lose the value of your money to inflation every day. You are not getting any interest for keeping cash in your house, and there is a chance of you getting robbed.
So, what is the solution?
In very urgent situations, cash is the only thing that will help you fast, but there are also drawbacks to having cash in your house.
To solve this, you can have a small percentage of your emergency fund as cash in your house so that not all of your money is getting affected, and you have quick cash for any situation.
The general rule of thumb is to have one month’s expenses as cash in your house.
A savings account is an excellent way to keep your money since you can access your money within hours, and you get some interest for keeping your money in a bank.
Liquid mutual funds
Liquid mutual funds are the best place to park your money because you get higher returns than a bank savings account. Also, they are easy to liquidate. You can get your money in 2 to 3 business days. Liquid mutual funds are debt funds that invest in Certificates of Deposits, treasury bills, government securities, etc. It is a low-risk mutual fund that is best suited for an emergency fund.
Short-term fixed deposits
Short-term fixed deposits are fixed deposits with a maturity period of fewer than 12 months. They give higher interest than a bank savings account, and if you don’t want to park your money in a mutual fund but still need good interest for your money, then a short-term fixed deposit is the best option.
The ratio most experts recommend is 20:20:60.
Keep your money in this ratio:
- Twenty percent cash
- Twenty percent in a savings account
- Sixty percent in a liquid mutual fund or Short-term fixed deposit
Why do you need insurance?
Though an emergency fund can cover your monthly expenses for 6-9 months, It is not suitable for covering a medical bill for an extended period or covering all damages on your house during natural disasters.
If you use an emergency fund for things like this, you will dry up your money in no time, and it will not be enough to cover everything.
That’s why you need insurance. Insurance will cover your huge medical bills and property damages for only a modest premium.
Conclusion of the emergency fund
Everybody will face some rainy days in their life. If you are prepared well for it, you can face it without having any problem like having an umbrella in the rain. But if you didn’t prepare well, you will get washed away in the rain. That’s why it is crucial to have an emergency fund that will protect you from any obstacle.