How to build an adequate emergency fund

What is an emergency fund?

Life is uncertain as it is full of shocks and surprises, but we can equip ourselves to bravely face these uncertainties. When we talk about an unforeseen financial emergency then an adequate emergency fund can certainly come to our rescue by working like an immunity booster to our finances. It can help us tide over the difficult time without getting mentally stressed and financially exhausted. for example- outbreak of deadly disease, job loss or any kind of natural disaster like floods, earthquakes, pandemic like the Covid-19.

Taking reference of current pandemic Covid-19, no one in their dream could have thought of such a virus very dangerous in nature that can suck up the whole economy in no time. People who built an emergency fund are better off because even if they were not getting salaries; offices are shut; factories are shuttered down during lockdown, they could still manage their expenses and can sleep peacefully without worrying much by having a financial safety net of emergency funds with them.

What are different kinds of emergency funds available in the market?

Depending upon time horizon, there are two kinds of emergency funds available in the market:

Long–term emergency funds: These funds are for greater intensity emergencies like a major natural disaster or a sudden medical emergency. This fund should be invested in instruments that allow you to earn a slightly higher rate of interest but may take a couple of days to liquidate.
Short-term emergency funds: These funds are for relatively lesser intense emergencies. These offer little in terms of interest but are quick to get a hold on cash as emergency crops up.

How should we build an emergency fund?

There is no single method to decide the ‘how’ part of this investing decision as it depends on various factors like risk appetite, income, expenditure, time horizon, intensity of emergency etc. These factors vary from individual to individual. Building an emergency fund will require some financial prudence and financial awareness. Before putting your money in an emergency fund, you would like to think through about the following aspects:

Figure out all the sources of your income: Determine your monthly income from various sources and how much of it is getting saved on a monthly basis.
Figure out your expenses: Make a separate list of variable and fixed expenditure (Rent, maintenance, mortgage payment, insurance premiums, other loans (car/ education), school fees, and salary for staff (house help / driver)). Then try to ascertain which kind of expenditure is consuming a larger portion of your income and which one can be cut down in order to save more.
Keep regular investments intact: Don’t hamper your regular investments in order to save more for emergency funds.
Set a goal: Setting a goal is very crucial as it will work as a motivator to keep putting some funds aside on a monthly basis for emergency fund. The rule of thumb is that you need to save three to six months expenses as your emergency funds, but it may not apply on you so set a goal which suits your finances instead of frantically following others.

After performing above four crucial steps, take out money for emergency fund from your budgeted income.

Now, the question arises – Where to allocate funds for creating an emergency fund?

You can choose to allocate this investment across various streams instead of keeping it in only one. You can spread your funds into high interest savings bank account, low risk –high liquidity vehicles like a Certificate of Deposit. These funds can offer potentially better returns than idle cash, at relatively lower levels of risk. They can also be liquidated within a quick span of time. It would be prudent to start it with the first salary cheque of yours. Be regular until you have enough for rainy days. Keeping these factors in mind, you can try the 10:20:70 method for allocating your emergency fund in following manner:

Cash in hand:Keep 10% of the money in liquid cash because keeping too much cash is not desirable as inflation loses its value over a period.
Savings account: 20% of the money will get locked for some time and will earn an interest. Do a thorough research and search which bank or investment funds is yielding high interest for saving accounts with minimal fee required.
Investment: Keep 70% of the fund either in short-term deposits or liquid mutual funds. Both these debt instruments have minimal risk, and they are highly liquid, too. Money market instruments are great tools to park your emergency funds with them. These are easy to use and come up with no fees or minimal fees. Investments can be liquidated easily
Certificate of Deposit: These offer a fixed rate of return for a duration of time which varies from one year to seven years. Do not get tempted to early withdrawal as you may incur a penalty.

Start with small amount

Don’t overburden yourself at the beginning, start with relatively small amount and then gradually increase the size of it.

Avoid exhausting your savings

Invest a small portion of your savings in emergency funds but on regular intervals.

How to manage an emergency fund?

Managing an emergency fund is as important as creating an adequate emergency fund. Some points to be taken care of after creating an emergency fund:

Experts suggest that one should keep emergency fund in an entirely separate bank from his regular bank in order to reduce the temptation to draw from it. “Out of sight, out of mind—until you really need them.”
It is advisable to put your emergency fund on an automatic transfer mode so that it can automatically deduct from your account at the start of the month. Investors can either set up an automatic deposit on payday or a separate direct deposit with their employer as part of the steps to start an emergency fund.
Even if you reach your desired adequate emergency goal, you should not stop putting your money in an emergency fund. Life is uncertain and you may face some another financial emergency so continue to set aside funds for emergency.
Cut down on your unnecessary monthly bills so that you have some breathing space available.
Set practical and reasonable milestones in order to create a healthy balance between your savings and emergency funds given your necessary expenditures.
Make a habit of tracking the progress of your emergency fund and take professional help to grow your funds efficiently.
Psychological behavior plays an important role in any kind of investing decision and so is the case with emergency funds. Think of emergency funds as an insurance as it will encourage you to keep your future financially secure.
Don’t withdraw money from it to finance your other expenses; be firm and disciplined with regards to your emergency fund and set some exceptions where you can withdraw it and how you should compensate for it.
Once you have accrued enough in your emergency fund, you could think of educating one of your family members to start an emergency fund as it may free you off from some financial burden
If two or more than two family members are earning, then you can also choose a combined emergency fund by aligning your interests.

Conclusion

To conclude, an emergency fund can make a sea difference in times of contingency and woks as an imperative tool to unabashedly face any kind of financial setback. It is not just ordinary people who save for emergencies, one could learn it from Reserve Bank of India, as it saves in the form of Contingency Fund to meet the unforeseen and unexpected economic shocks. The government of India maintains different types of contingency funds to absorb economic emergencies. Everybody should have an emergency fund for financial protection.

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