Nothing is certain in life. Our lives are bounded by several uncertainties. Many may not be financially prepared to tackle the crisis that strikes them unexpectedly. An unplanned expenditure could cause huge distress to the family. Emergency funds are the precautionary measures we ought to take under this situation. So, let’s prepare ourselves before any major crisis comes gushing our way.
What is an emergency? What is an emergency fund? What is the difference between an actual emergency and a hypothetical one? Why are such funds important? What should be the size of these funds?
How to build and manage an emergency fund? How to redeem these funds? Are some of the questions that will be answered in this article. Let’s get started.
How To Build An Emergency Fund?
In this article
These funds are not generated overnight. But the corpus grows gradually with time. Initially, it may not be a big deal to contribute. But with time the contribution will increase and demand more commitment. Every month individuals should plan and make a budget for themselves. They should set aside some amount towards emergency funds.
1. Track Your Monthly Expenses
The first step in building an emergency corpus is to decide its size. The size varies from one individual to the other. Therefore, individuals should track their monthly expenses. The monthly expenses are inclusive of fixed expenses and variable expenses. Once these expenses have been tracked the size and the time required to generate the corpus will be determined. After tracking these expenses, the non-essential expenses should be curtailed and discarded. Let’s understand this through an example.
Fixed Monthly Expenses
Reduced Fixed Monthly Expenses
As can be seen from the two tables individuals should trace their expense and discard the non-essential ones. In this way, they will be able to reduce the monthly expense and calculate the emergency corpus. Once the fixed charges are sorted they should proceed towards the variable expenses. The variable expenses should also be handled in the same way. Tabulate all the monthly varying expenses then disregard those that are not essential. This will create a clear picture of the individual about his monthly expenses.
2. Decide The Monthly Contribution Towards The Emergency Corpus
Every month individuals spend money to meet expenses. But they should also save money to contribute towards the emergency funds.
After deciding on the amount, the savings should not stop. This should continue until the minimum corpus is generated. Therefore, individuals will have to calculate their expenses for 3-6 months. Then make sure that this is the minimum amount that is accumulated in the emergency funds. This amount should be calculated as follows:
(Monthly fixed expenses + Monthly variable expenses) * Number of months.
3. Invest The Emergency Funds In Another Account
The amount saved every month should be invested in liquid mutual funds. These mutual funds should not clash with the individual’s investment. It is preferable to invest in emergency funds in a separate account. This should be done to ensure that these funds are not used elsewhere.
4. Set A Fixed Amount For The Rainy Days
Automate the transfer towards the emergency funds in the other account. This will ensure a regular contribution towards the emergency funds.
5. Cut Down On Monthly Expenses
Reduce the monthly expenses by setting saving goals. The non-essential charges should be cut-off from the monthly expenses. This will ensure that more funds are transferred to the emergency corpus.
6. Sell Things That Are Not Required
There may be many household items that are required. Getting rid of these items will create more income. The additional money earned can be contributed to the emergency funds.
7. Make More Money
Try and increase your income by engaging in a side business. This could be a part-time job, working overtime, or starting a small business. The extra money earned can also be contributed to the emergency funds.
Let us consider an example. Suppose the monthly income of an individual is Rs.40,000. He spends Rs.20,000 on his monthly expenses. The remaining Rs.20,000 are his savings. These savings can be invested in various investments to generate an emergency corpus.
i. Recurring Deposit (Gradual saving)
This is a great tool for generating emergency funds. If the monthly expenses of the individual are Rs.20,000 then the emergency funds will require a minimum of Rs. Rs.1.2 lakh. To generate this corpus the individual will have to deposit Rs.2,500 every month for at least 4 years.
ii. Premium (Life Cover)
Life cover depends on the age of an individual. For younger people, the premium cost is less as compared to older people. To buy a term plan cover of Rs.1.2 lakh, Rs.2,000 will have to be deposited every month.
iii. Premium (Health Cover)
Purchasing a health cover and paying the monthly premium for an initial 3 years is highly recommended. This will establish the necessary credit. The monthly premium of Rs.1,800 per month is enough to buy a cover worth Rs.5 lakh.
iv. Premium (Motor Cover)
Similar to health cover a motor cover of Rs.5 lakh can be purchased by paying a premium of Rs.1,500. The car insurance claim should be avoided to minimize the premium amount.
v. Premium (Property Cover)
If the property owned by an individual is damaged then the cost can be compensated by buying a cover for the property. This requires a premium payment of Rs.350 per month.
How To Manage An Emergency Fund?
The funds generated over time have to be used efficiently. Thus, every individual should plan and strategize its utilization to its maximum potential. These funds can be arrayed in the following manner.
The emergency funds are intended to assist the investor during a crisis. Therefore, they should not be invested in any equity or equity-based funds. This can pose a high threat of capital attrition which should be avoided in long run.
The emergency funds should be easily accessible to their investors during an emergency. There should be no delay in the convenient access to these funds for immediate expenses.
This refers to the time taken for the conversion of funds from investments to cash. It is advised to make investments in a redeemable account. So that the investors are not penalized with pre-withdrawal charges.
15:15:70 is a good method for arranging these funds. According to this method
- 15% of the funds should be kept in liquid form. The amount is restricted to 15% as deploying too much cash in liquid funds will result in its loss of value due to inflation.
- 15% can be deployed in the savings bank account. This will enable the funds to generate a small interest. This will also ensure quick access to emergency funds. But these funds will suffice only for small emergencies.
- 70% should be invested in investment plans. These plans can either be short-term plans or mutual funds. Life insurance is one such tool that protects individuals against any tragedies. Medical insurance is another tool that covers soaring medical bills. Motor insurance and property insurance covers the cost of repairs. This involves any damage to the vehicles or property.
Where To Invest An Emergency Fund In India?
Every month savings should be set aside for emergencies. These savings will automatically grow into an emergency corpus with time. Sometimes people may create an emergency corpus for themselves.
But they may end up spending it elsewhere. Individuals must keep this corpus aside. They can do this in different ways. The investors should invest the emergency funds in investment tools that are
a. Easily Accessible
When an emergency strikes there should be no delay in accessing the funds. The redemption process should be simple and not time-consuming.
b. Offer High Returns On Investments
The interest rate offered on the funds is important. For long-term emergency funds, the interest rate is important. It should be high as these funds are meant to deal with long lasting emergencies. For short-term funds, the interest rate could be a decent number. But it is always safe to generate a huge emergency corpus for the rainy days.
c. Safe From Market Risks
With the fluctuation in price, the invested amount is always at risk. Thus, the investment tools where the prices are volatile aren’t good options. Also, the size of the corpus shouldn’t be changing. It should remain constant as this ensures the seamless recovery of the corpus.
d. Liquidity Should Be Maintained
The ease of access should be easy. This implies that the funds should be converted into cash in the least number of days. If the liquidation occurs in 10-15 days then this, not a good tool. A minimum of 2-3 days should be taken for liquidation of the emergency corpus.
What Are Emergency Funds?
Emergency funds are a part of an individual’s savings. These are savings that have been set aside to deal with any unforeseen situations. Unplanned vacations, new purchases of a house, and college education are not emergencies.
The emergencies include house repairs, car crashes, illness, job loss, and so on. Mismanagement of finances can cause a lot of distress to every individual. Thus, every individual must plan for such unexpected financial crises in advance.
This will prevent unnecessary stress. Thus, individuals will be able to lead a peaceful life even in times of crisis. These funds do not fortify financial stability. But they lighten the burden on one’s shoulders by a huge margin.
Why Are Emergency Funds Important?
Emergency funds are of paramount importance. They come handy during financial emergencies. These funds can handle unplanned expenses efficiently. They also ensure that there is no disruption of the lifestyle of any individual. Individuals with an emergency fund can always manage to stay afloat their sinking ship.
They can utilize these assets to prevent any distress from affecting their regime. Thus, emergency funds ensure a seamless route for individuals during their time of crisis. Some may think of using their credit cards during tough times. But this will only add to one’s adversities as the debt will keep on rising. Let us look into the details by considering an example.
In the first case let’s assume that Mr. Naik uses his credit card during an emergency. The emergency could be anything like the ongoing COVID pandemic. Mr. Naik has been forced to take a paid leave by his company. Now his monthly income has reduced from Rs.30,000 to Rs.10,000.
But the monthly expenses of his family will almost remain the same. With some adjustments, they have managed to cut costs but by a small margin. So, let’s look at the numbers if he decides to meet his expenses by using his credit card.
As can be seen from the table the credit card increases the debt of an individual. As the monthly expenses were increasing the credit card usage also increased.
After meeting the limit on the credit card usage Mr. Naik had to compromise his investments. Thus, he sold a part of his investments to meet the increasing debt. In the end, he was left with a net worth of only Rs.30,000. This is a huge dip in the investment considering the lump sum he had earlier.
Now, let us consider another situation wherein Mr. Dessai is prepared to face an emergency. He has already prepared himself by accumulating an emergency corpus worth Rs. 2 lakh.
These funds have been generated through gradual savings in the savings account. Since he has already prepared his safety net let’s see how he deals with this emergency.
His company has also decided to give paid leave to some of the company employees. His monthly salary has now dropped to Rs.10,000 from Rs.30,000 which he earned earlier.
Since he already has an emergency fund, he won’t have to rely on his credit card and add to his debts. Let us look at the figures in Mr. Dessai’s case.
In the second case with the presence of an emergency fund, Mr. Dessai’s net worth is better than Mr. Naik’s. The emergency funds have successfully rescued Mr. Dessai during his adversities.
With the reduction in his monthly salary, he was still able to survive the tough time without compromising on his lifestyle. He managed to meet all his expenses without touching his investments. In this way, his net worth was not adversely affected.
He did not even require his credit card to aid his finances. Thus, preventing the additional debt. He has effectively handled his finances because of his emergency fund. Therefore, it is right to say that emergency funds are of paramount importance.
Who Needs Emergency Funds?
The shortest answer would be every individual needs to have an emergency fund. Certain circumstances make it important to have an emergency fund. Some of the situations are as follows.
1. Every individual owns a property and a vehicle. In this case, every individual should avail of the property and motor covers. These premium covers will include unexpected damages to the property and the vehicles. So that individuals do not have to spend money from their pockets.
2. If the monthly income is meager. In such cases, the income levels of the individual are not stable. Therefore, they need to create an emergency fund for their survival during a crisis.
3. Your family is dependent on you. If you are the sole bread-winner of the family then you have greater responsibilities. The dependence of members leads to the greater usage of the income. As the expenses are increased savings should also be generated to grow the emergency corpus.
What Should Be The Size Of An Emergency Fund?
All of us have different needs. The monthly income is spent in different ways to lead a peaceful life. The size of an emergency fund is not constant. It depends on various factors for instance the needs of an individual. But the bigger the funds the better it is. The size of the emergency corpus varies. This is because every individual has his own financial needs. But to save something for the rainy days it is necessary to start from somewhere. Let us start with the minimum monthly expenses. This includes
1. Fixed Expenses
Expenses like house rent, EMIs for pending loans, education, insurance premiums are the fixed expenses. These are the ones that remain constant. Every monthly expense that cannot be avoided should be considered. This excludes movie tickets and money spent on leisure activities. Such activities should be curtailed and avoided to save money.
2. Variable Expenses
This includes the monthly electricity bills, phone recharges internet charges, DTH bill payments, groceries, and other expenses that are always varying. Expenditures for shopping, vacations, dine-outs, OTT subscriptions should be excluded from the emergency corpus.
After calculating the total monthly expenses, the emergency fund generated should ensure your family’s survival. The duration of survival should range between 3-6 months without any income.
Suppose the monthly expenses on a family (inclusive of fixed and variable expenses) sums up to Rs.20,000. Then an emergency corpus of Rs. 1.2 lakh to Rs.2 lakh should be created for any emergency.
Types Of Emergency Funds
The emergency funds are further be divided into two categories. They are
i. Long-Term Emergency Funds
Major emergencies like natural calamities or global pandemic require long-term funds. These funds consist of a lump sum. To create such funds the individuals should deposit their savings in high interest generating schemes. These investment tools should be liquidated within a minimum number of days.
ii. Short-Term Emergency Funds
Any immediate financial emergency should be tackled with the help of these funds. They can be invested in any scheme which offers a modest interest rate. And provide instant access to the deposits.
Why Should Emergency Funds Be Liquid?
Funds in the liquid form have a slight advantage over the amount deposited in banks. These funds should be liquid to make unexpected disbursements. Thus, emergency funds should be parked wherever withdrawals are easy. There should be no delay in these withdrawals.
Withdrawal of these funds should not be accompanied by any pre-withdrawal charges. And it must generate excellent returns. Every emergency cannot be dealt with insurance covers. Motor tire repairs may cost around Rs.1,000- 2,000.
Repair of household appliances can cost around Rs.5,000-10,000. These are unforeseen charges that may not be included in the budget. Therefore, individuals need to be prepared to face these charges.
Composition Of Emergency Funds
The emergency funds should be created by adopting two methods:
1. Gradual Saving
Through gradual savings, the individual should generate a corpus. The corpus should enable the family’s survival for at least 6 months without income. Here individuals must know the monthly expenses of the family. By keeping a track of these expenses, they can accumulate the corpus. It can be generated by saving a part of the income every month. In this way, the funds will grow and ensure financial stability during emergencies. If the monthly expenses of a family are RS.50,000 then the emergency funds sum to Rs. 3 lakh.
2. Premium Payments
This is another of preparing for emergencies. Individuals can prepare themselves by availing of several insurance plans. This includes
i. Life Insurance
This is an essential cover that every working individual should avail of. It protects the worst tragedies of life. The life insurance cover should include a minimum of 120 times the monthly income of the worker. Let’s assume that the current income and the current expenses of a family are Rs.1 lakh and Rs.50,000. Then a life insurance cover for the member should be 120 times the income. This sums to Rs.1.2 crore. The life insurance cover for the homemaker could be 6 times the income. Which comes to Rs.60 lakh.
ii. Health Insurance
The health of every person is of prime focus. The modern lifestyle may have an immense effect on the health of a person. Health can deteriorate anytime. But the cost of treatment is not economical. The bill may create distress for the patient and his family. Thus, health insurance is a must today. It may be provided by the company of working employees. But they should also buy another for themselves. This cover should be approximately equal to 5 times his income. With an income of Rs.1 lakh, expenses of Rs.50,000. The family health cover should be around Rs.5 lakh.
iii. Motor Insurance
This insurance cover is mandatory for every owner. Road accidents and other tragic incidents are unforeseen. Whenever any such damage occurs the insurer gets the full on-road price of the vehicle. The minimum cover should include the basic policy and the add ons. The basic policy is a comprehensive cover. Zero depreciation is the add on that should also be included in the cover. The luxury car owners should opt for the consumables cover and the return to invoice cover too.
iv. Property Insurance
The property cover includes all the damages to the house of the individual. This includes fire protection that is a risk of fire. The damages are caused by nature like lightning, cyclone, and storm. Explosions of bombs, damage due to plane crash, riots, and strikes. The property insurance cover should be 150 times the EMI from the home loan. Or else it could be 1.0 times the property value.
List Of Some Investment Tools
Some of the investment tools are as follows:
1. Savings Account
Parking emergency funds in a savings account is a good option. Such accounts are risk-free and it offers the benefits of liquidity. But it is better to maintain separate accounts for regular and emergency savings. So that the investors do not spend money from the emergency reserves.
2. Fixed Deposit
A fixed deposit with the smallest tenure of at least 10 years is also a viable option. The funds from the savings account can be successfully transferred into an FD. They should be kept undisturbed in the fixed deposits. Fixed deposits generate a huge interest on the parked funds. The percentage at which the interest is earned is between 7% to 9% per annum.
3. Gold ETF
Investment in a Gold ETF is not subjected to any inflation or any price fluctuation. Instead, the value of gold always surges with time. It is highly beneficial to every investor. As the buying and selling of ETF are better than purchasing physical gold.
4. Mutual Funds
Mutual funds have excellent returns. These funds are only invested in risk-free securities. Thus, investment in mutual funds is also highly recommended.
5. Liquid Funds
Liquid funds are the best tools to invest in emergency funds. These funds provide a lot of flexibility to investors. They generate huge returns as the interest rate for these funds is not less than 7.5% per annum. They also allow online investing and redemption of the funds.
6. Short-Term Debt Funds
These funds guarantee decent returns to the investor. The money can be easily redeemed online within 1 or 2 days.
Redemption Of Emergency Funds
The emergency funds may be deposited in any of the schemes, mentioned above. Most of these schemes are highly liquid. Thus, investors will have immediate access to their assets within a few days.
The redemption procedure allows the investors to claim Rs.50,000 or 90% of the deposited funds. These funds will be instantly credited to the investor’s bank account. It is the same account that was linked while starting the investment.
Investors must pay attention to the availability of the redemption facility before investing. They should invest their savings in different accounts. These accounts should be liquid and easily accessible. This way they will not face any financial trouble during crises.
Personal Loans And Other Debts
Many times, individuals think of availing loans in times of crisis. This may be due to the non-existence of an emergency fund. But this is not a good way of fulfilling the monetary gap.
It could be the result of mismanaging the emergency funds. Healthcare expenses are the main causes of availing loans. It can be avoided by investing in a healthcare cover. Such covers ensure that the huge medical bills are not shelled from our pockets.
Availing a personal loan, depending on the credit card during a crisis is a bad idea. It adds to the debts of an individual. This is an inefficient way of tiding over emergencies.
Individuals should always opt for debt linked plans. These plans offer high liquidity and small volatility. They should invest their cash in such reserves and refrain from further debt.
What Is An Emergency?
Now that we know the significance of emergency funds let us define a financial emergency. A financial emergency is any expected situation that involves expenses. It demands the instant use of money.
Here are a few examples of financial crises.
- Loss of job: There are chances that the company may lay off its employees due to several reasons. One cannot avoid this possibility. Therefore, they should be financially prepared to support themselves during this time.
- Severe medical ailments: Medical emergencies can strike anytime. Most health covers are not inclusive of every disease that any individual is likely to contract. This can create a huge hole in an individual’s pocket if he is not prepared in advance.
- Car accidents or breakdowns: Tragic incidents like these are unannounced. Thus, emergency funds are the airbags to such instances.
- Last minute travel expenses: This may be due to a death in the family. Or any other unavoidable reason that demands traveling.
- Important repairs of major household appliances like air-conditioner, roof, or electronic devices.
- Extra income tax: There instances that an employee may be having an income tax liability. It can create a deduction in his salary. But the emergency funds can always make up for the decrease in income.
- Global or National emergencies like the Covid-19 pandemic: This is an emergency that has immensely affected the economy. The business and professional lives of many individuals have been badly hit. Companies have laid off several employees due to cutting costs.
What Is Not An Emergency?
Sometimes people may have the wrong idea of a financial emergency. They may misuse the amount saved for the rainy days. Hence, it is important to educate the common man.To know the meaning of an actual emergency we need to differentiate between needs and wants.
Here are some examples of situations that are not worth spending on emergency funds.
- Healthcare issues like plastic surgery. Getting yourself a facial makeover isn’t a need but a want.
- An expensive vacation like a cruise. Vacations are for leisure purposes.
- Last minute travel expenses for a wedding or any family functions.
- Replacing household interior décor. This can wait as there are greater priorities than these.
- Achieving financial goals of making expensive purchases like a dream car or house.
Related Frequently Asked Questions
1. What is an Emergency Fund?
An emergency fund is a cash reserve set aside for meeting expenses during emergencies. This amount is made up of 3-6 months of expenses. So that individuals can live a peaceful life during emergencies.
2. Why do we need an emergency fund?
It helps to tackle unforeseen expenses. In case of loss of a job, an individual will not be able to sustain his family. Here an emergency fund comes handy to meet the daily requirements of the family even without a source of income. They are better than credit cards as they do add to debts.
3. Is an emergency fund similar to savings?
Yes, it is similar to savings. As the emergency funds are easily accessible and liquid savings account is a good investment option. But care should be taken that the inflation rate should not be greater than the interest rate. Then the funds will not be grown.
4. What should be the size of an emergency fund?
These funds should be enough to meet the expenses for 3-6 months without any monthly income.
5. Where should the emergency funds be parked?
The emergency funds should be parked in debt linked funds. So that they are volatile and easily accessible.
6. Where should the emergency funds be used?
The emergency funds should be used to meet the expenses of:
i. The period of job loss.
ii. Home repairs.
iii. Vehicle repairs.
iv. Medical emergency
v. Family emergency.
7. Should the emergency fund be stored in cash?
No, it is recommended to keep the emergency funds in liquid form.
8. How to build an emergency corpus?
The emergency corpus can be generated as follows:
i. Calculate the monthly expenses.
ii. Save money to contribute towards these funds.
iii. Get rid of the non-essential expenses.
iv. Create a separate account for emergency funds.
v. Make sure that the minimum corpus is generated.
The future is unpredictable. So, emergency funds act as a buffer. They enable us to brace ourselves for any financial disaster that may strike us. But, it is also necessary to differentiate between an actual emergency and a hypothetical one. Individuals should instill the habit of small savings. This can be achieved in so many different ways.
The methods mentioned in this article should be adopted. Every family especially the middle-class should implement these. After the close evaluation of monthly expenses, the non-essential expenses should be avoided.
This way the savings will be enhanced. These enhanced savings should be invested in any low-risk investment plans. These plans should be easily accessible and should generate huge returns. The mature funds can be withdrawn during financial crises. This will ensure the financial stability of the individual and his family.
The emergency fund is a safety net of every investor. This ensures that major crises do not take a toll on his lifestyle and peaceful living. The bigger the funds the longer will be the survival of individuals during an emergency. So, let us pledge to create an emergency fund for ourselves so that we do not fall prey to any financial emergency.