In this blog, we will discuss the second step of the beginner’s personal finance checklist, which is to build an emergency fund.
Estimated read time: 3 minutes and 2 seconds
Hint: Having an emergency fund is like wearing a bulletproof jacket to reduce the impact of a crisis.
Buckle up, here we go!
What is an emergency fund?
As the name suggests, this fund is for emergency usages like loss of income due to job loss or salary cuts, medical emergencies not covered by insurance, unexpected expenses, etc. We should not use this fund for our routine expenses.
This fund sounds similar to our piggy bank or dog house toy we used as kids to save money, right? Good old days!!!
Do you need this fund?
YES!!! Having an emergency fund is a must! Your age, sex, work, income level, etc. doesn’t matter. Everyone needs this fund.
You shouldn’t start investing without an emergency fund. That’s how important it is because, without it, you will feel like fighting the dragon monster in Super Mario with one last life and no power-ups. Do you want to take the chances of ruining all your progress?
Now, if you have understood the importance of this fund, let’s get to how to build and manage it.
Building an emergency fund:
A basic thumb rule is to save at least 6 months of your basic expenses like rent, food, important bills, etc. You can save for more than 6 months if you want to play safer based on your risk appetite.
If you already have some savings, check if it is enough to cover 6 months of your expenses? If not, you need to allocate more money every month towards your emergency fund.
You can either save a lump sum amount for the emergency fund if you received your bonus or have the money set aside for something less important. Or, you can start saving some amount every month to build your emergency fund.
How to manage an emergency fund:
We should park our emergency fund in liquid assets, where you can withdraw the money when you need it without delay. This helps you to take care of any financial emergency without disrupting your investments that are focused on your long-term goals.
Emergency funds need to be invested in less risky instruments. We have 3 options –
- Bank savings account
- Bank Fixed Deposit (FD) or Recurring Deposit (RD)
- Short-term liquid debt mutual fund
The goal of parking your emergency fund is to safeguard your money and earn decent returns to beat inflation to some extent.
To minimise risk, you can invest your money in all the 3 investment options by dividing the fund into parts.
You can invest the first part, which is 3-4 months’ worth of funds, in short-term debt mutual funds. We can liquidate these liquid funds in a couple of days, and they have also been providing returns of 6-8% on average.
Pro Tip: Once created, you won’t be accessing your emergency fund regularly. So if you hold the debt mutual fund investments for more than three years, you gain an indexation tax benefit!
If you are not comfortable with debt mutual funds, you can park the funds in FD or RD. Now, don’t get triggered by the mention of FD. Many have spoken against FD, but during a recession or market crash, fixed deposits save your money.
But FD and RD add charges if you liquidate it before time, and interest returns are also fully taxable beyond Rs.10,000.
Next, you can park 2-3 months of funds in your savings account. It is always better to keep separate savings accounts to park your emergency fund. You shouldn’t use this account unless it’s an emergency.
And finally, you can keep 1 month’s worth of funds in cash at home.
As we always say, you need to think and build an emergency fund based on your goals and risk appetite. You may feel at peace if you have 12 months’ worth of basic expenses or park all your funds in the savings account. It is okay because having an emergency fund is more important than thinking about the returns, charges, etc.
In our next blog, we will discuss life and health insurance and how insurance with an emergency fund acts as a concrete wall of safety for you.
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