Building an Emergency Fund in 2020
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24 Jun, 2020
We make plans for every stage of our life – a new home, a new car, marriage, exotic holidays, our children’s education, and our retirement. We even do our best to combat inflation with a well-strategized investment plan. However, everything in life cannot be planned. While we knew that in principle, the Covid-19 pandemic taught us that planning for such situations to the best of our ability is a financial priority. Events like Illnesses, pay-cuts, financial crises, accidents, and deaths of loved ones are a few examples of unplanned circumstances. While these events are emotionally draining, they can potentially drain your savings.
If you build an emergency fund, you will have a cushion when life delivers a blow. The most logical question is if we have no details of the emergency, how would we save for it? The following guidelines can help you shield yourself and your family from any financial crisis.
How do you begin planning for the emergency fund?
First take stock of all your monthly living expenses – rent, utilities, food, fees, insurance, loan repayment(s), transportation, and personal expenses. Next, take stock of all your income – salary, interest payments, bonus, etc. Once you calculate your income and expenses, you can start building your emergency fund.
How much do you save for the emergency fund?
It is advisable to build an emergency fund equivalent to 6 months of your expenses. The rationale being that during an emergency, you can cover all the mandatory, monthly expenses, until you get back on your feet. If you are expecting your income to fluctuate, you can set aside an additional 3 months of expenses. Create a savings budget by setting aside a fixed amount of your monthly income and manage your expenses from the balance account. If you get a bonus/promotion, invest a part of it towards the emergency fund, ergo easing the burden on your cashflows, and expediting the savings process.
How do you invest for the emergency fund?
You can start building the emergency fund by diverting a part of your monthly surplus and invest it appropriately. While selecting investment instruments for the emergency corpus, keep in mind that you need it to be safe and easily accessible. Therefore, invest in low risk and liquid investments, even though the returns on liquid investments may not be as high. Savings bank account and liquid mutual funds are both good options for this purpose. However, don’t keep all your savings in the bank only. Consider investing a larger portion of it in liquid and ultra-short term mutual funds. They are easily accessible, more tax-efficient, and are a better alternative to your savings account.
What are the other factors that determine the emergency fund?
The responsibility of your emergency fund does not end with saving. You should review your emergency needs at regular intervals, as they may evolve over time due to lifestyle changes and/or other factors. Furthermore, factors such as financial stability, age, health, job security, number of earning members, and the number of dependents in the family. If you are a business owner, it may prove wise to have a contingency plan to cover business emergencies as well.
What should you not spend your emergency fund on?
At times it may be tempting to spend the money you have set aside for an emergency. However, remember that the fund isn’t liquid money and you should utilize these funds only when absolutely necessary.
Saving and earmarking funds for a rainy day is an important financial habit to inculcate. Not only does it protect you and your family in case of an unfortunate event, but it will prevent you from cashing in your long term investments when the need arises.