Emergency Fund – Why, when, and how to build it? Life is full of uncertainty and surprises. Nobody knows what to expect at the next moment. An emergency can happen at any point in time. The COVID-19 pandemic is the best example of that. Businesses shut down, many lost their jobs all of a sudden. Many, if not all, struggled to pay their bills and had a tough time. What went wrong?
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What is an emergency fund and how does it work?
An emergency fund is a corpus intentionally created to meet uncertain financial emergencies. In other words, an emergency fund is a fund reserved to meet unplanned and unavoidable expenses without hurting your financial position.
Having an emergency fund comes in handy when you are to face an unforeseen emergency. If you miss out to build an emergency fund, you may have to risk your financial footing. You may go for extra credit from banks which in turn can affect your credit score badly.
Now the million-dollar question is, How to build an emergency fund?
How to build your Emergency Fund- A brief guide
There are many ways to build an emergency fund. Just piling up some money and locking it on your safe is not a good idea to build an emergency fund.
If you want me to make the whole process simple, I would suggest you allocate your money into liquid investments like debt funds, short-term RD’s, and some cash in hand to meet short-term financial emergencies.
Suppose you have Rs. 2 lakh accumulated as your emergency fund. The smartest thing you can now do is to keep Rs.40,000 in cash at home, let Rs.40,000 stay in your savings bank account and invest the remaining Rs.1,20,000 in liquid investments.
Emergency Fund - Key points to remember
As an old saying goes “NEVER PUT ALL THE EGGS IN ONE BASKET” the same holds true for emergency funds as well.
Make sure these three points are taken care off
- Liquidity – Fund should be liquid providing easy availability in case of an emergency.
- Security – The capital should not get eroded by market fluctuations or based on the changes in external factors
- Diversity – Maintaining diversity in the portfolio will help to get better returns and reduce the risk in the portfolio.
Consider investing in large-cap funds, government bonds, corporate bonds, etc. so that your fund will have sufficient diversity and security.
The biggest concern you should have while building a long-term emergency fund for a large unanticipated expense is that it should give consistent risk-free returns and should beat the inflation.
Emergency Fund - Investment avenues available
The best investment avenue for building long-term emergency funds are high-interest FD’S or bonds. Alternatively investing in index funds is also a good option to consider. To gain decent returns in long term(with low risk), investing a portion in endowment assurance policies are also recommended.
Besides, you can consider investing in high-growth large-cap companies with strong fundamentals. However, you should limit stock market investments to less than 40% as they are an attractive yet riskier choice in the long-term.
The emergency fund will later help you to meet your long-term needs such as children’s marriage, education, etc.
HOW MUCH EMERGENCY FUND SHOULD YOU HAVE?
The exact amount you should save as an emergency cannot be prescribed because the requirement varies from person to person.
However, the general rule of thumb is to set aside your 3-6 months salary as your emergency fund for short-term emergencies. In case of a long-term emergency fund, You should pump in at least 5% of your annual salary as a long-term emergency fund.
WHEN SHOULD I START BUILDING AN EMERGENCY FUND?
You should start building an emergency fund as soon as you start working (irrespective of you are debt-free or not). The earlier you start building it, the better.
Human life is full of uncertainties. What matters is to be happy in life. For that, we need financial freedom. Building an emergency fund and using it wisely can be a good start to your path to financial freedom.