Emergencies are unwelcome guests that have the potential to burn all your savings and investments. Also, mismanagement of these emergencies can ruin your financial objectives.
We usually make the mistake of starting to invest in risky assets without emergency fund savings and protection plans in our financial planning.
This mistake can make it difficult for you to achieve your goal of financial stability. The first step towards financial stability is building adequate emergency funds.
What is an Emergency Fund?
An emergency fund is money that you keep aside to tackle life's unpleasant surprises. Such a fund should be utilized only in the case of financial crises and unplanned situations.
The COVID-19 pandemic made many people realise the importance of keeping aside emergency funds. However, emergency fund savings do not exclusively associate with medical emergencies.
They can include any unexpected expenditure apart from routine expenses. Any breakdown of regular income, such as loss of job, loss in business, or physical injury can be the reason to build an emergency fund.
In short, an emergency fund can act as a parachute when financial planning is done properly.
How to calculate it? Here’s an easy Emergency Fund Calculation:
Emergency fund calculation is quite easy and definitely not rocket science – as some might believe.
Here is a quick & short formula to know your emergency fund amount.
The ideal rule says you should have an emergency fund equal to 6 to 12 months of your regular monthly expenses.
So, you have to calculate your regular monthly expenses and multiply them by 6 or 12.
E.g. If your monthly expenses are Rs.40,000/-
You have to save emergency funds equal to Rs. 2,40,000 (40,000*6) to Rs. 4,80,000 (40,000*12).
Where should you keep your emergency funds?
It is important to note that emergency funds are for your hard times when you need money the most and hence, you must keep your emergency funds in a place where it is easily accessible i.e. you must keep them in highly liquid assets
Divide your emergency fund into 2 equal parts.
Invest one part in a fixed deposit and the remaining can be invested in assets like liquid funds, ultra short-term funds, etc. based on your risk profile.
You can also consult a financial advisor on which scheme would be the best for you to invest your emergency amount.
Tips and Tricks to Build an Emergency Fund
1. Always consider loss the risk of losing your income.
If you are a salaried individual, you must factor in the risk of losing your job. In case of a high probability of job loss, you can have an emergency fund of closer to 12 months. On the contrary, if you have job security or a fixed employment contract, 6-9 months of emergency funds would be enough to protect you from unseen financial distress.
2. Number of dependents can affect your emergency fund calculation.
The number of dependents you have and their personal circumstances can change the amount of emergency funds you need.
If you have people who are critically dependent on your income for example family members with chronic medical conditions or ageing parents, this increases their dependence on your emergency fund, so you can have up to 12 months of your regular expenses in your emergency fund.
Bottom Line
The primary objective must be being financially stable as soon as possible, which can be achieved by managing your expenses and investing strategically building an emergency can be a good start to cover the whole journey.
Emergency fund savings not only help you during an emergency but also make you more confident to explore high-risk high-return investments & help you plan finances better.