How much Emergency Fund is Required & How to Build it?

Reasons why having an emergency fund is important are given below:

1. Emergencies can occur unexpectedly, requiring financial preparedness.
2. Individuals and families face various fixed monthly expenses like groceries, utilities, EMIs, rent, and school fees.
3. Without an emergency fund, an income loss can severely impact finances as expenses continue despite halted income.
4. An emergency fund serves to bridge the gap during periods of higher outflows than inflows.
5. Building an emergency fund is crucial, despite the challenges of saving.
6. The fund should be easily accessible for withdrawal when needed.
7. Options for parking the emergency fund include bank accounts, term deposits, or liquid mutual funds.

Features Of a Good Emergency Fund

Some of the features of a good emergency fund are given below:

1. An emergency fund serves as a financial safety net for unexpected events.
2. Surplus income and tax refunds can be utilized to establish an emergency fund.

1. Key characteristics of an emergency fund include liquidity, security, and separation from investments.
2. Liquidity ensures easy accessibility during emergencies, making liquid mutual funds a recommended investment avenue.
3. Security entails opting for low-risk investment options, such as short-term fixed-income securities and bonds.
4. It's essential to keep emergency funds separate from investments to maintain their intended purpose as a financial safeguard.

How Much Emergency Fund Is Required? 

Depending on your income and expenses, an emergency fund should ideally cover three to six months' worth of your monthly income.

For instance, if your monthly income is Rs.30,000, and your routine living expenses amount to Rs.15,000, your emergency fund should range from Rs.60,000 to Rs.1 lakh. 

Alternatively, you can split your emergency fund into two categories:

1. Long-term emergency funds: Reserved for major emergencies like natural disasters or sudden medical expenses. These funds should be invested in instruments offering slightly higher interest rates, but it may take a few days to liquidate.
2. Short-term emergency funds: Accessible immediately during emergencies, even though they offer minimal interest. These funds serve as immediate financial support until you can access your long-term emergency funds.

Where Should You Keep Your Emergency Fund 

1. Once you've determined the amount you intend to invest in an Emergency Fund and commenced saving towards it, finding an appropriate place to store it becomes crucial. A savings account emerges as a practical choice due to its liquidity, especially during crises.
2. Look for a savings account offering a high interest rate without imposing minimum balance requirements or hefty fees. However, since Emergency Funds are not frequently accessed, you can explore investing a portion of this fund in an instrument that provides better returns and liquidity than a Savings Account.
3. Certain Mutual Funds, such as liquid funds, offer enhanced liquidity and returns compared to savings accounts while maintaining minimal risks. By allocating a significant portion of the Emergency Fund to these schemes, you ensure liquidity as redemption is possible within a short timeframe. On average, liquid funds yield returns ranging from 6-8%.
4. Another essential aspect of an Emergency Fund is its construction. Suppose your monthly basic living expenses amount to Rs.40,000. In that case, you'll need to save between Rs.2-2.5 lakh for your emergency fund. Given the escalating cost of living, achieving this goal may take time. However, you can expedite the process by leveraging Debt Mutual Funds.
5. With low risks and the potential for substantial returns, these funds facilitate the creation of the corpus within a shorter duration. Initiating a Systematic Investment Plan (SIP) and automating your savings and investments can accelerate progress. Additionally, you may consider investing your annual bonus in these funds to expedite reaching the target amount.

Why Do I Need Emergency Fund in India

1. The primary purpose of an emergency fund is to address unforeseen expenses, making liquidity its paramount characteristic.
2. When deciding where to allocate your emergency funds, prioritise liquidity above all else. It should be easily accessible, allowing you to withdraw funds promptly and without any delay.

1. Moreover, ensure that there are no penalties, such as exit loads or pre-withdrawal charges, associated with accessing the funds.
2. Additionally, safeguard the principal amount invested to prevent any depreciation while also aiming for attractive returns.

How to Build an Emergency Fund

Building an emergency fund is a gradual process that cannot be accomplished overnight.

Allocate a specific sum of money each month into a separate bank account dedicated solely to this fund. Over time, this fund will accumulate into a substantial corpus that can provide financial security during unexpected situations.

For instance, if your goal is to establish an emergency fund of Rs.1 lakh, you can commit to setting aside Rs.5,000 or Rs.10,000 every month until you reach your target amount. It is acceptable to reduce investments temporarily to prioritize the development of this fund.

When should I Use the Emergency Fund?

Situations when you should use your emergency fund are given below:

1. Coping with Financial Strain Due to Job Loss: In case you are facing any financial problems in the event of a job loss, tapping into your emergency fund becomes imperative. Unless you have an alternative income source, utilising your emergency fund is the primary recourse. However, if your income has dwindled, consider adjusting your budget to trim expenses, preserving your emergency fund for future contingencies.
2. Meeting Uninsured Medical Expenses: While comprehensive health insurance is vital for addressing medical emergencies, it may not cover all treatments. Dental procedures, pre-existing conditions, and certain outpatient treatments may require out-of-pocket payments. Opting for a personal loan to cover such costs may entail hefty interest charges and EMIs. Utilizing your emergency fund for these expenses eliminates concerns about interest costs and future debt obligations.
3. Addressing Emergency Home Repairs: Emergency repairs to your home, prompted by incidents like fire or water damage, may not be fully covered by home insurance due to specific exclusion clauses. The expenses incurred for such repairs can be substantial, necessitating the use of emergency funds. Opting for emergency funds over additional debt not only saves costs in the long run but also expedites the repair process.
4. Covering Emergency Travel Costs: Last-minute travel due to family emergencies can strain finances, especially considering the high costs of airfare. Using your emergency fund to finance such travel expenses is prudent, as it eliminates the need for immediate repayment and minimizes interest charges associated with credit card usage.

Conclusion

In the modern era, many individuals aim for early financial independence, aspiring to retire in their forties with their financial needs met. Achieving this goal requires careful planning and strategic investment, starting with the establishment of an Emergency Fund to cover unforeseen expenses.

While building an Emergency Fund may seem unnecessary during stable economic periods, it proves invaluable during crises such as the current lockdown.