In uncertain times, having a financial safety net is crucial to navigating unexpected challenges without compromising your financial stability. One essential aspect of personal finance is building and maintaining an emergency fund. In this article, we will delve into the key aspects of creating an emergency fund, addressing common questions, and exploring viable investment options.
At its core, an emergency fund is a financial cushion designed to cover essential expenses in unforeseen circumstances. Whether facing a sudden job loss, medical emergency, or other unexpected events, having a dedicated fund ensures you can meet your financial obligations without resorting to loans or depleting your investments.
The preceding pandemic has imparted numerous financial lessons, emphasizing the importance of life and health insurance alongside the need for an emergency fund. This article aims to guide you in planning an emergency fund for the year 2024.
Understanding the Emergency Fund
Often referred to as a contingency fund, the emergency fund is a financial reserve created to address short-term crises. Whether it’s a medical emergency or a sudden loss of income, having an emergency fund in place facilitates navigating such situations with composure.
Building an Emergency Fund
To establish an emergency fund, consider essential inputs such as fixed costs, insurance premiums, and interest payments. Create a comprehensive list of non-negotiable expenses, including rent, utilities, groceries, medical bills, and more. These are expenditures that cannot be deferred, even in the face of income loss.
Example Calculation
For instance, if your monthly fixed expenses amount to Rs 30,000, annual insurance premium is Rs 25,000, and your EMI is Rs 20,000, your emergency fund calculation would be Rs 3.25 lakhs (Rs 1.8 lakhs for fixed expenses (6 months 6 * Rs 30,000), Rs 1.2 lakhs for EMI (6 months 6* Rs 20,000), and Rs 25,000 for the annual insurance premium).
How to Invest for an Emergency Fund in 2024
Once you’ve determined your emergency fund corpus, consider dividing it between sweep-in bank fixed deposits and liquid funds. Allocate the amount equally between the two. For a calculated corpus of Rs 3.25 lakhs, invest Rs 1.63 lakhs in sweep-in bank FDs and the remaining amount in a high-quality liquid fund.
Read: Building an Emergency Fund: A Financial Lifeline
Investing in a Liquid Fund
When choosing a liquid fund, ensure that it meets specific criteria, such as a minimum assets under management (AUM) of not less than Rs 20,000 crores, average maturity of 90 days or less, and a negligible credit risk. Opt for funds with exposure only to government securities or AAA-rated bonds, and monitor the expense ratio.
Determining the Size of Your Emergency Fund
A general rule of thumb suggests that an emergency fund should cover at least 6 months of essential expenses. However, for added security, experts recommend preparing for the worst and creating a fund equal to 6 to 12 months of expenses. Exclude non-essential expenses like vacations and outings when calculating the fund size to keep it reasonable.
Case Study: Practical Steps to Build Your Emergency Fund:
A person’s financial information is given below,
| Monthly income | 40,000 |
| Savings/month | 12,800 |
| Expenses head | Category | Amount |
| Rent | Needs | 10,000 |
| Bike loan EMI | Needs | 3,500 |
| Utilities | Needs | 2,000 |
| Groceries & food | Needs | 2,500 |
| Leisure | Wants | 2,500 |
| Insurance premium | Needs | 1,700 |
| SIP | Investment | 5,000 |
| Total expenses | 27,200 | |
| Need-based expenses | 19,700 |
As we are looking for the emergency funds only, we must ignore the wants and investments.
| Need-based expenses | 19,700 |
| 6M emergency fund | 1,18,200 |
| 12M emergency fund | 2,36,400 |
| Savings/month |
12,800 |
| Money set-aside for emergency fund |
10,000 |
| General savings |
2,800 |
|
Case 1: No extra effort |
||
| Money set-aside for emergency fund |
10,000 |
|
| Months | Years | |
| Time to build 6M emergency fund | 11.82 | 0.99 |
| Time to build 12M emergency fund | 23.64 | 1.97 |
|
Case 2: Reduce leisure expenses & investments by 50% |
||
| Money set-aside for emergency fund |
13,750 |
|
| Months | Years | |
| Time to build 6M emergency fund | 8.60 | 0.72 |
| Time to build 12M emergency fund | 17.19 | 1.43 |
|
Case 3: Case 2 + investing lumpsum |
||
| Money set-aside for emergency fund | 13,750 | |
| Lumpsum (Unexpected gains – Festivals, Annual bonus) | 40,000 | |
| Months | Years | |
| Time to build 6M emergency fund | 5.69 | 0.47 |
| Time to build 12M emergency fund | 14.28 | 1.19 |
| 6M emergency fund | 78,200 |
| 12M emergency fund | 1,96,400 |
- Case 1: Investing Rs 10,000 every month takes 1 year for 6 months’ of emergency funds.
- Case 2: We reduce the wants by 50% to achieve the targets early and take 9 months to build 6 months’ emergency funds.
- Case 3: As some expected gains occur, it also helps to build the corpus early, but that is exceptional in individual cases. Here we expect the Rs 40,000 unexpected gains contributing to emergency funds to reduce the time where 6 months’ emergency funds are getting accumulated in only six months.
Investment Options for Your Emergency Fund
Once you’ve determined the size of your emergency fund, the next crucial step is deciding where to park the money. Three viable investment options,
Savings Account with Sweep-In Facility
- Offers flexibility with FD-like returns.
- Activating the sweep-in facility ensures excess funds are converted into a flexible fixed deposit, providing easy access.
Debt Mutual Funds
- Includes short-term and corporate debt funds.
- Low to medium risk with returns slightly better than inflation.
- Liquid funds, in particular, are considered safe and offer higher returns than traditional savings accounts.
Combination Approach
- A combination of savings account, liquid fund, and corporate debt fund.
- Allows for a balanced approach, catering to varying risk appetites.
Building an emergency fund is a vital aspect of responsible financial planning. Regularly reassess your fund requirements based on changing circumstances, and consider increasing it from 6 to 12 months of expenses over time. Discipline is key during this process, and while it may be tempting to indulge in non-essential expenses, maintaining focus is crucial for long-term financial well-being.
Conclusion
In the unpredictable landscape of personal finances, an emergency fund serves as a vital cushion. By comprehending the essentials of building and investing in such a fund, you fortify your financial resilience, ensuring that unexpected situations can be navigated with financial stability and confidence in the year 2024.
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.
