An emergency fund is a key part of your personal finance which is meant to take care of any sudden, unexpected and unavoidable expenses. Every individual should maintain one and decide allocation to it based on their stage in life, liabilities and responsibilities.
Here is what you should know about emergency funds.
What is an emergency fund?
An emergency fund is the money that one needs to keep aside to tackle an unexpected setback one might face. With these savings, one can be better prepared to deal with medical crises, job losses, etc, without having to depend on loans.
How large should your emergency fund be?
How to build an emergency fund?
Be slow but consistent while starting to build an emergency fund and grow it gradually.
Take into account your current financial condition. Start by calculating all the necessary expenses such as electricity bill, water bill, internet bill, petrol/diesel bill, equated monthly instalment (EMI) towards home loan, groceries, monthly rent, etc. While planning an emergency fund, you may wish to consider some of your recreational and lifestyle choices too.
If you think you are in a stable job, build a buffer that amounts to three to six times your calculated monthly expenses. If you think your job may be at risk or if you have dependents with medical conditions, extend the time to nine to 12 months for a comfortable living. Any additional money received such as bonus should ideally be diverted to the emergency fund, at least partly.
With rising inflation, revisit and revise the amount you save for your emergency fund every year. In case you use up your emergency fund, you should strive to build it up again in the next few months, so that you are financially secure again.
Where should you park your emergency funds?
As the name suggests, these funds should be readily available for use in a time of need. So, you should save them in instruments like savings accounts, where they are safe and immediately available. Another option can be sweep-in fixed deposits. And finally, a part of it should also be invested in liquid mutual funds. Note that investments should be done in instruments with low risks and high liquidity, meaning they are easy and quick to withdraw from.
Factors on which your emergency fund depends
Allocation to your emergency fund depends on various factors such as whether you are single or married, whether you are a “dual income, no kids” (DINK) couple or with children, whether you are under debt or debt-free, and the stability of your job. For instance, in case of children, you would have added expenses such as education costs, medical costs, etc, that cannot be ignored.
Overall, saving for emergency needs is not optional. While one cannot predict uncertainties of life, one can always prepare better to deal with them.
FAQs
How many months of expenses should the buffer cover?
The number of months of expenses a buffer should cover depends on the kind of income of the person – stable (three months), standard (six months), unstable income (12 months).
Should the money sit in a savings account, fixed deposit, or liquid mutual fund?
Emergency money should not be parked in just one instrument but a combination of them. Priority should be given to safety, liquidity and then returns. It is recommended to keep up to 2 months of money in a savings account, which is safe investment and can be accessed immediately, and the rest (up to 6 months) in fixed deposits or liquid mutual funds for better returns.
When is it right to use the buffer and how fast should it be rebuilt?
Emergency money should not be used until there is an absolute need for it. These are mostly used in cases of medical emergencies, expenses during job losses, such as school fees, daily expenses, EMIs, etc. You should never use buffer money to upgrade your lifestyle, or invest in risky or illiquid assets. In case you have used a small part of your emergency money, you should rebuild it at the earliest, maybe within 1-2 months.
How should the amount change after marriage, children, debt, or job uncertainty?
The emergency fund money differs based on the stage of life a person is in. To calculate the amount, calculate the essential monthly spending and multiply it with the number of months to build the emergency fund. For singles, it could be assumed to be around 3 months, for married people it could be 6-9 months, and for couples with children, people with a high debt or job uncertainty, the time could be around 12 months.