Emergency Fund: Key things to keep in mind when building one

Vimal Joshi
Updated: 07 Jan 2022, 09:54 AM IST
TL;DR.

Emergency fund is a contingency savings fund meant for a rainy day, or a long monsoon. It has gained more significance in the COVID era than ever before. But before you start to save, you should have a concrete plan. Read further to know what are the key things to remember before creating an emergency fund

The conventional wisdom warrants that accumulated savings should be large enough to take care of our emergencies.

The conventional wisdom warrants that accumulated savings should be large enough to take care of our emergencies.

If some contingency hits us, all of us tend to first dip into our savings or liquid assets. Some investors, on the contrary, use their credit cards or borrow money via personal loan. The conventional wisdom warrants that accumulated savings should be large enough to take care of our emergencies. This fund comprising accumulated savings that can be used in an emergency is also known as an emergency fund.

How much corpus you create in an emergency fund depends on a host of factors such as your long-term goals, numbers of members in your family, possibility of medical emergencies, and so on and so forth.

Once you have created an emergency fund, you must know where to keep it i.e. in savings account, fixed deposit, mutual funds, gold or equity.

As a matter of fact, the emergency fund ought to be separated from regular savings. And it should ideally bring some interest. However, it is vital to note that the rate of interest you earn on emergency funds is less important than the instant availability of the fund.

This is why one should avoid risky investments while keeping money aside for emergencies. “The emergency fund should be invested in safer savings instruments such as fixed income instruments or blue-chip stocks. The risky investments such as a stock of a small cap company or high risk bonds are a strict no-no for emergency fund,” says Deepak Kumar Aggarwal, a Delhi-based investment advisor and a chartered accountant.

These are the key things to know while building an emergency fund:

1. Savings before expenses: Warren Buffet once said “ Do not save what is left after spending. Instead spend what is left after saving”. Following his advice, try to save on a regular basis beyond your regular savings notwithstanding your expenses. For instance, if your monthly income is 80,000 and you save 25,000 a month. Now, beyond that if you want to create an emergency fund, you can keep another 10,000 per month aside. This allocation ought to be kept in a separate account and not mixed with the regular savings.

2. Unexpected cash inflow: When you receive an unexpected cash inflow such as by tax refund or bonus, it can ideally be put in the emergency fund.

3. Standing instructions: Giving standing instructions to the bank to transfer a small sum every month to an account meant for emergency fund is vital to allocate a portion of income to emergency fund.

4. Shifting money to another account: When you are saving for an emergency in a savings account that offers four percent interest rate, you can transfer the fund to a fixed deposit that can give you interest at a higher rate of interest, maybe six percent. Since both are liquid savings, there is no hassle in keeping the emergency fund in a fixed deposit account.

5. More than one emergency fund: When the accumulated emergency fund grows beyond a threshold, you can create two emergency funds. For instance, when you believe a fund of 10 lakh is sufficient for an emergency.

There is nothing wrong in keeping two fixed deposits of 5 lakh each, instead of one account with a total balance of 10 lakh. Likewise, if you want your money in an emergency fund to earn an income, you can put a part of it in a mutual fund and the remainder in a savings or fixed deposit.

6. Saving it further: When an emergency fund is partially exhausted after some time and some of it is still unspent, then it is advisable to continue to treat it as an emergency fund instead of spending it or transferring it to another account. An emergency doesn’t necessarily strike once, it can happen again. So, the habit of keeping aside a portion of income or saving for an emergency fund is a long-term habit that is meant to be sustained.

 

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These are the key things to keep in mind if you are building an emergency fund. 

So, we can highlight that an emergency fund is an accumulation of savings meant for contingencies, and one must save religiously each month to make the fund swell. Also, any sudden cash inflow ought to be routed to this fund.

 

First Published: 07 Jan 2022, 09:54 AM IST
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