Everything You Need To Know About Emergency Funds

15 Feb 2021  Read 454 Views

You might have heard that "Failing to PLAN is planning to FAIL!", but have you planned for your future? 

An emergency would never knock on your door; it would just smash through the window and would leave you no time to prepare. Now, you cannot possibly prepare yourself for all types of emergencies; however, you can prepare yourself for things that deal with money. 

So, in case of an emergency, you must have a fund ready to address your financial concerns.

Here is everything you need to know about creating and maintaining an emergency fund so that you can prepare yourself to combat another economic strain like the COVID-19 pandemic, without getting stressed financially.

What are Emergency Funds?

As the name suggests, an emergency fund is a fund that acts as a lifesaver in case of an emergency. It is a readily available source of liquid assets that can be used in case of financial problems. We should not use it in routine, but we should review it periodically to make the necessary modifications.

Why should you maintain an emergency fund?

Risk can be minimized, but it cannot be eliminated. We cannot predict the risk, so we should prepare for it very much in advance. So an emergency fund has become a necessity to minimize the impact of undesirable financial situations like the ones that occurred in 2020.

The unemployment rate rose to OVER 20% during the lockdown period!! Isn't that drastic? 

Also, the majority of people employed in the private sector had to take pay cuts. It led to a reduction in their household expenditure. The situation was such that some professionals had to resort to Selling vegetables to earn a living! Therefore, it is always advisable to have an emergency fund to avoid such situations.

How Much Amount is Required?

The average time to find a new job is three months. Therefore, it is advisable to have at least 3 to 5 months' expenses as your emergency fund. Considering your average monthly expenditure to be Rs 50,000, you should have at least 1.5 Lakhs as an emergency fund. But it should be more than Rs 2 Lakhs, to be on the safe side.

The invested amount should be divided into long-term and short-term funds so that more returns can be earned, without compromising with liquidity. 

  • Long-Term Fund: We should use this fund for extensive emergencies like medical situations, natural calamities, or the unemployment of the primary income earner. This amount is not urgently needed; hence it can be slightly illiquid where returns can be higher with the lowest risk possible. Liquid debt mutual funds are the most appropriate investment tool. They give higher returns than Bank FDs, aside from being less risky. We can withdraw them on demand. 
  • Short-term Fund: This fund should be highly liquid. It should be immediately accessible in case of an emergency, although the returns can be relatively lesser. The best option is to keep the amount in cash at your home or in a Savings Bank Account. We can withdraw it by debit card. We can also use a credit card to increase the amount, but we should use it only in case of an emergency.

Where to Invest?

Do you also face problems regarding where to invest your emergency fund?

As mentioned earlier, your fund should be able to generate adequate returns. You do not want to lose to the inevitable evil called inflation, do you? At the same time, it should be immediately accessible to overcome an emergency. After all, what is the point of having an emergency fund if we can't use it at the time when it is most required?

And so, you would want to make a proper portfolio to achieve the objectives. It should contain liquid funds and Bank FDs/ RDs. For example, if you desire to have a fund of Rs 2 Lakhs, then you can invest as follows:

Investment

Amount

Returns

Liquidity

Cash

30,000

NIL

Highly Liquid

Saving Bank Account

40,000

3%

Highly Liquid

Bank FD

50,000

5-6%

Liquid

Liquid Mutual Funds

80,000

5-7%

Liquid

Liquid Funds allow instant redemption of up to 90% of the invested amount. The redeemed amount gets credited into your bank account in the blink of an eye.

How to Build an Emergency Fund?

If you have read the article so far, you would know how important it is to build an emergency fund. And now, let's get to know how you can create an emergency fund smoothly and effectively.

  • Save First, Spend Later: It is rightly quoted by the legendary Warren Buffett, "Do not save what remains after spending; instead spend what remains after saving." We recommend saving an adequate amount of your monthly income to build the emergency fund. Try to accommodate the regular expenditure within the balance. Not only will this help in accumulating the needed fund, but it will also inculcate a habit of saving among the family. After creating the fund, we can invest the savings for the long term. It will help us attain the benefit of the 8th WONDER of compounding, and it will also be beneficial in planning for retirement and achieving life goals like owning luxuries.
  • A penny saved is a penny earned: Did you know that you can save up to Rs 45000 taxes annually by investing? We can use the tax saved to build our emergency fund. Why give your hard-earned money to the government when you can use it to fulfil your goals? Instead of expanding it, we can use it to reduce the burden of savings on the emergency fund.

                                   

Conclusion 

The government has taken many initiatives to reduce the economic effect of the COVID-19 pandemic. But we should also try to become financially Atma nirbhar by keeping ourselves insured from any emergency by making a fund for the same. The fund should amount to about four months of expenditure to ensure that you are in the same boat as you were in before the crisis.

Besides being liquid, it should generate modest returns. It will make it grow without further investment. The best way to do so is to invest in Liquid Mutual Funds

We should save at least a fair proportion of income and utilize tax refunds effectively. Else we can reduce the expenditure by spending it judiciously. In the end, "Save your money, and one day your money will save you."

About the Author: Prasuk Jain | 37 Post(s)

Prasuk is an inquisitive and tenacious person with a mix of enthusiasm and a positive attitude, currently pursuing CA. 

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