Emergency Fund: How to build?

Why to build an Emergency Fund?

The most important step in financial planning is to build an emergency fund. As the name suggests it is a fund that helps you tackle emergencies that could be financial hardships like a job loss, a medical emergency or some other emergency that requires funds to see you tide through it. Obviously, emergencies come unannounced and so it pays to be prepared.

If we take the example of this pandemic, lots of people either lost their jobs or faced salary cuts. Those who had emergency fund could tide over the rough times more easily compared to those who did not.

How start building an Emergency Fund?

Building an emergency fund is a process that does not happen in a day but is a gradual process. One cannot build an emergency fund when one faces an emergency, it needs to be built beforehand. Here, we look at the steps to build an emergency fund.

1. Calculate how much you need

This is the first step. Experts recommended that you have an emergency fund that covers 6 months of your expenses. If you are in a profession where you have a fluctuating income, an emergency fund would need to cover 9-12 months of your expenses.

When calculating your expenses, make sure to include all expenses such as rent, groceries and school fees. Expenses like EMIs (if any) and insurance premiums for life, health and other insurances also needs to be factored in. One can leave out discretionary expenses, but once you have an amount, it is safe to keep a 15-20 per cent buffer to be on the safe side. If your total expenses are coming to Rs 50,000 a month, your emergency corpus needs to be Rs 3 lakh.

It's worth, having a discipline to save regularly.

2. Set up a monthly goal

Now that you know the amount required, set a goal. If you want to build a fund of Rs 3 lakh over a year, you will need to put away Rs 25,000 every month. Have a monthly goal that does not seem too daunting and something that is doable.

3. Start putting money away

The corpus may seem daunting, so you need to have a plan. Start putting away small amounts of money regularly towards your emergency fund. This does not need to put a stress on your cash flow. To begin with cut down on discretionary expenses as much as you can. Cut down on coffee at expensive hotel; put off buying a new gadget and contribute to your emergency fund. Instead of eating out weekly, you can bring it down to twice a month.

4. Automate your savings

Out of sight is out of mind. You can set up an auto debit to a separate savings account as soon as your salary or other income hits your bank account. Set the amount at something you are comfortable with; it can be as low as Rs 5,000 a month. This way you ensure that there is a minimum contribution to your emergency fund every month. Remember, the more you save, the faster you will be meeting your emergency corpus goal. Remember that you need to control your temptation to dip into these savings for regular need for funds.

5. Use lumpsum receivables

Any amount you receive as a lumpsum, whether it is a bonus or a gift, should be put in your emergency fund. The temptation is to splurge such money, but such lumpsums can help you meet your goal for building an emergency fund much faster.

Where to keep the money?

When investing the money for an emergency fund, it is important to keep the money in an account that is liquid and safe. The money can be withdrawn anytime as it is meant for emergency use. One should not expect high returns from the investment as in general, high returns does mean high risk. Try to keep it distributed between a savings account, and a bank FD.

Starting from 2020, RBI has announced that " each depositor in a bank is insured up to a maximum of ₹ 5,00,000 for both principal and interest amount held by the depositor. Another reason why emergency fund should be in a bank as it is covered under depositor's insurance through RBI. Refer What to look when opening a Bank Account?