How to Build an Emergency Fund? - Steps, Benefits & More

It is said that a picture speaks a thousand words, but a number can save a thousand lives. Numbers like 100, 101, 102, 108, 112, and 1,091 aren’t just digits. They become lifelines for Indians in times of need. Whether it is a medical emergency or a security threat, the nation has active helplines to provide immediate assistance. However, taking measures for emergencies should not stop at the national level. It is equally important to be emergency-ready with your personal finances. One of the most crucial tools for this is an emergency fund. This article will delve into the meaning, importance and steps to systematically build an emergency fund. 

What is an emergency fund? 

An emergency fund refers to a corpus created by regularly setting aside money to prepare for the uncertainties of life. It can be viewed as a financial cushion that you can fall back on during challenging times. 

An emergency fund is different from a regular savings fund as the money is earmarked only for unplanned expenses. These can include running the family during a job loss or paying for urgent house repairs. 

Why should you have an emergency fund?

Whether it is the unfortunate sinking of a giant ship or an economy battling the consequences of a pandemic, history has repeatedly highlighted the significance of being prepared for emergencies. Here are four key reasons why an emergency fund is a crucial tool:

1. It builds financial discipline 

Even if you are fortunate enough to avoid situations that call for unplanned expenses, building an emergency fund largely contributes to inculcating financial discipline in life. When you save and invest regularly, you tend to rationalise your spending – a positive move toward a financially secure future. 

2. It stops you from resorting to debt to fund your expenses 

The gravity of an emergency often impacts the ability to make sound financial decisions. The desperate situation it creates sometimes compels you to resort to debt, which, if not planned well, can quickly spiral into a debt trap. With a steady emergency fund, you can tackle the challenges without any reliance on credit. 

3. It keeps your long-term financial plan unaffected 

While you may be saving and investing diligently for your long-term financial goals, an emergency can be powerful enough to wipe off those savings in an instant. When faced with adversities, you might not hesitate to dip into your savings. Ultimately, you might end up compromising on your goals. On the contrary, an emergency fund ensures that your goal-based planning remains undisrupted even during crises. 

4. It reduces financial stress 

Knowing that you have an adequate fund to deal with the uncertainties of life brings mental peace. With a stress-free mind, you are better able to focus on the issue at hand and make sound decisions.  

How much should an emergency fund have?  

The ideal amount for an emergency fund varies across individuals. It depends on several factors, such as income, lifestyle, family size, financial commitments and other circumstances. As a general rule of thumb, it should have enough money to cover three to six months’ worth of living expenses. For someone with a monthly salary of 1 lakh and corresponding expenses of Rs 80,000, setting aside Rs 2.4 to Rs 4.8 lakh may seem daunting. However, if planned well and an early start, it is achievable. 

How to build an emergency fund?

Building an emergency fund is a systematic process with defined steps as follows: 

Step 1: Calculating emergency fund target 

Begin by calculating your monthly expenses, such as Equated Monthly Instalments (EMIs), rent, utility bills, and fees. If your monthly expenses amount to Rs 40,000, multiply this by the number of months you want to stay covered for. If you want to build a safety net for six months, your minimum target amount will be Rs 2,40,000.  

Step 2: Determining the contribution amount 

Once you know your target amount, figure out how much of your monthly disposable income you can allocate to the fund. If your monthly income is Rs 80,000, you will have a disposable income of Rs 40,000. Of this, let’s say you decide to keep Rs 5,350 aside each month for emergencies. 

Step 3: Investing the earmarked amount 

Mere setting aside the contribution amount won’t be enough. To build your fund faster, you must invest it. Keeping Rs 5,350 per month in cash will take you 45 months to create your desired corpus. 

Where to invest the money for building an emergency fund?

To experience a seamless fund creation journey, look for the following features when choosing your investment:

1. Liquidity: Emergencies strike without warning. So, you must have access to your money at all times. Traditional investments, such as the Public Provident Fund (PPF) and National Savings Certificate (NSC) are popular saving schemes but suitable for the long term. On the other hand, stocks and mutual funds offer better liquidity, making them suitable for emergencies. 
2. High returns: Different investments offer different returns, which can be fixed or market-linked. While fixed-return investments guarantee safety, market-linked investments such as mutual funds or Unit Linked Insurance Plans (ULIPs) offer high growth potential. ULIPs also provide insurance coverage, an added advantage while preparing for emergencies. 
3. Risk: Stocks and equity mutual funds have the potential to deliver high returns, but they come with a risk factor. However, mutual funds offer a wide range of options with varying risk profiles. For instance, debt funds carry lower risks than equity mutual funds. Overnight funds, a type of debt fund, are often considered suitable for building emergency funds because they invest in securities having a maturity of just one day, thereby offering high liquidity. Systematic Investment Plans (SIPs) in mutual funds further mitigate market volatility. 

Conclusion

An emergency fund becomes the much-needed financial support during crises. To be able to tackle unforeseen situations confidently, it is important to have an emergency fund that is adequate and liquid.