‘75% of Indians do not have an emergency fund and in the event of a sudden layoff, they could default on their EMIs’, according to a Survey titled ‘India’s Money Habits’ by personal finance platform Finology. The survey also states Indians often look up to their parents or friends in case of an emergency.
What is the big deal about emergency funds and how does it affect your personal finance journey?
In this blog, we are going to answer all your questions about emergency funds.
Table of contents
​What is an emergency fund? |
Why do you need an emergency fund? |
How much to keep in an emergency fund? |
How to build an emergency fund? |
Where to park the emergency fund? |
When to use an emergency fund? |
What is an emergency fund?
An emergency fund is a saving or reserve you set aside to help you cope with emergencies or unexpected events in your life like a job loss, unplanned medical expense, urgent house maintenance, etc.
Why do you need an emergency fund?
Imagine your house needs some maintenance and it cannot be delayed any longer. It is expected to cost you around Rs. 50,000. But, you have only Rs. 10,000 in hand because you spent most of your savings on a family vacation recently. That means you have to arrange the remaining Rs. 40,000. You are left with no choice but to use your credit card or take a loan from a friend.
Suppose you used your credit card and finished the maintenance work. You need to repay the loan the following month.
You saved some money out of your salary and paid off a part of the credit card outstanding. But, the interest gets charged on the outstanding. Did you know, that credit card interest ranges from 40 - 55%?
Come next month. You couldn’t save anything from your salary due to some unexpected expenses. You are unable to repay the outstanding and the credit card interest keeps mounting.
You get the idea right? You would be in deep trouble if this cycle continues.
But, imagine if you had an emergency fund of Rs. 1 lakh saved for such unexpected expenses. You wouldn’t have to worry about the increasing credit card dues.
Now that you have realised the importance of an emergency fund, it brings us to the next question.
How much to keep in an emergency fund?
After all, how much emergency fund is enough?
To find out let us take the worst case of emergency that could happen - A JOB LOSS.
In an emergency like a job loss, you have to deal with all the expenses without a salary. You need to figure out all your NECESSARY EXPENSES. Remember, going for a movie or a weekend trip IS NOT a necessary expense.
Here is an example of a household’s monthly expenses.
​NECESSARY Expense | Amount (Rs) |
EMI | 30,000 |
Utility (Electricity & Water) | 1000 |
WIFI, Phone recharge | 1000 |
Grocery | 7000 |
Petrol | 2000 |
Gas | 1000 |
Medical Expenses | 1500 |
Child Expenses | 2500 |
Travel expenses | 1000 |
Miscellaneous | 3000 |
​Total Monthly Expenses | 50,000 |
According to the calculation, we have calculated the monthly necessary expense as Rs. 50,000.
According to experts, it is ideal to keep 3 to 6 months of monthly expenses in an emergency fund. Whether you want to keep expenses worth 3 months or 6 months or 1 year can vary depending on your life stage, employment type, individual risk tolerance, etc.
Suppose you are a family of 4 and you are the sole breadwinner of the family, you might need to be cautious and would want to keep a fund of 6 months’ expenses. Similarly, if you do not have a steady job, keeping 6 months of expenses would be ideal. However, if you are
single, then keeping 3 months’ expenses would do provided you can find a job within 3 months. Generally, if your risk tolerance level is low, to be on the safer side, you can be extra cautious and build a generous fund.
How to build an emergency fund?
This step is easy once you have figured out your NECESSARY EXPENSES. You would have decided whether you need 3 months' worth of expenses or 6 months' worth of expenses in your emergency fund.
How fast can you build the fund - It depends on what is left out of your salary after deducting the necessary expenses. If there is a considerable sum left, by sacrificing some luxuries like shopping, parties, etc. you would be able to build an emergency fund in say 6 months. Otherwise, you might take a little bit more time to build your required sum. Whatever the case, consistency and discipline are key.
Make monthly contributions as soon as salary hits your account - You would have figured out how much you can afford to keep aside every month in the previous step. Keep a separate savings account for the fund so that, you can make automatic contributions to the account from the salary account.
Boost your fund using lump sums and leftovers - Building an emergency fund as soon as possible is key. When you receive that annual bonus, why don’t you use some of it to build the emergency fund? If you have any leftover cash at the month's end, don't think twice. Send it to the emergency savings account. Every little contribution counts.
Increase your corpus based on requirement - Suppose you bought a new car on loan and have to pay EMI every month, the emergency fund has to be increased considering the new EMI outflow. When you become a new parent, the fund value needs to be increased considering the child’s expenses.
Replenish the account as required - Unfortunately, an emergency came up and you had to take some money out of the emergency fund. You should make it a priority to put back the money and bring the fund to previous levels.
Where to park the emergency fund?
Once you build the required emergency corpus, the next step is to evaluate your options to park the fund.
The appropriate product to park your emergency fund should have the following properties:
It should be extremely safe and not risky
It can be easily liquidated or in other words, can be easily sold
Its value should not be volatile (stocks or any such products that are extremely volatile are an absolute NO)
The following are some possible avenues to invest your emergency fund:
Cash - This is the easiest way to keep the fund. Easily accessible and CASH is still the king. But storing cash is risky. So, it is advisable not to keep cash beyond safe limits.
Savings account - This is one of the sought-after ways to keep the emergency fund. It is safe, accessible and as an added advantage, gives you some interest. Keep a separate savings account to park the emergency fund.
Bank Fixed Deposit - Better than a savings account because it pays you a higher interest rate and you have to break the deposit to use it. You won’t be tempted to break it unless it is a real emergency.
Overnight funds and Liquid funds - These are mutual funds that invest in high-quality debt instruments like T-bills, credit-worthy commercial papers, etc. These are a good option to park a part of your emergency fund. However, one must understand, that if you decide to liquidate the mutual fund, it takes 1-3 working days for the money to get credited to your bank account.
Note: In our entire discussion, we have discussed parking the emergency fund and not investing it. It is because we do not expect a return out of keeping it.
An ideal strategy would be to park a portion of your emergency fund in bank accounts (both savings and FDs) and the rest in liquid funds/overnight funds.
When to use an emergency fund?
You should be aware of what can be considered an emergency so that you can use the fund. As we have discussed in the beginning, job loss, illness, house maintenance, etc come under an emergency.
It makes more sense to discuss what doesn’t come under emergencies:
A sudden holiday planned with family/friends
Buying a luxury item that is on sale
A good stock you want to invest available at a great discount
Final thoughts
Building An Emergency Fund is a non-negotiable to succeed in your financial planning journey. Discipline and consistency are key to building a fund for the rainy day. However, defining an emergency, prudently using it when the need arises and replenishing it as soon as possible is the key. It goes without saying, that no matter your age, or life stage, an emergency fund works as the strong foundation in your path towards financial freedom.