In this ‘Emergency Fund’ guide, I will cover some important points in a step-by-step manner to help you build your own fund which will immensely help you during your worst times.
What is an emergency fund?
As the name suggests, Emergency Fund = Emergency + Fund (Money). It is the sum of money to put aside for a sudden life emergency like a complex medical urgency, or a job/income loss.
Why do you need an emergency fund?
You need this fund to protect you during your worst times. It is just like countries having nuclear weapons. Every country is trying to have it, but everyone hopes that they never have to use it. Like that, your emergency fund is your own nuclear weapon.
Some things to keep in mind:
– Never ever touch it, until you have 0 options left.
– Keep it liquid, so that you can quickly get the cash.
– Keep it secure & stable, don’t invest the fund in risky assets.
So why pay for insurance, if we build our own Emergency fund? Or why build an emergency fund when we already pay for insurance?
The answer is – Both are different. Insurance is very important but it does not cover all expenses and often it is not instantly accessible for many emergency situations. An emergency fund does both.
How much should you save?
If you’re on a fixed income i.e. monthly salary – 8 months of your salary.
If you’re on a variable income i.e. self-employed or freelancer – 1 year of your family’s monthly expenses.
If you have gone through my How to Save guide, you already have all the data about how much you are spending monthly. Now take the spending/expense of the last 3 to 6 months, make an average and get the monthly average expense.
Let’s make it simple. Last 4 months of your expense looks something like this
Month 1: ₹12,365
Month 2: ₹11,754
Month 3: ₹9,893
Month 4: ₹13,125
So, the average expense of 4 months i.e. (Month 1 + Month 2 + Month 3 + Month 4)/4 will be ₹11,784.25 and for making it simpler let’s round it to ₹11,800.
You have your average monthly expense i.e. ₹11,800. Now for a year of emergency fund, you need to save ₹1,41,600 (11.8k X 12)
Factors that should guide your Emergency Fund amount
> How you live – Rented Home or Owned Home.
> Nature of your income – Fixed or Variable.
> Nature of your job – Secure or Has risk of being laid off.
> Family members – Marital Status, Parents, Children.
> Family health status.
Should you build your Emergency fund first or invest that money?
Short answer is – First build the fund, later invest.
Long answer is – Only start other investments after building half of your emergency fund. So if the goal amount is ₹2 lahks, first accumulate ₹1 lakh for your emergency fund and then every month keep increasing it gradually along with other investments.
How to build an emergency fund?
First, decide the size of the fund by keeping all the factors (mentioned above) in mind. Personally, I am building a 1-year emergency fund. And you cannot build this fund overnight, it has to be done in a gradual manner. These are the steps you should follow:
- As I calculated above, for 1 year of emergency fund let’s say you need to save ₹1,41,600. So before making any other investments, save half of that i.e. ₹70,800 (1,41,600 divided by 2)
- Rest half i.e. another ₹70,800 – save monthly.
- Fix a time period. Personally, I aim to build my fund in 2 years (24 months)
- So, 70800/24 = 2950. Now you need to set aside ₹2950 each month for the next 2 years.
- You can start an auto-pay system in a Liquid Fund or Recurring Deposit. (I talk more about that below)
Where you should store your emergency fund?
First thing to know is – do not expect your emergency fund to give you high returns. That’s not the aim of this fund. Your primary aim should be to protect your fund and have mental peace, rather than high returns.
So, there are a few ways you can store your emergency fund:
- Savings Bank Account – 2.5 to 3% yearly interest
- Recurring Deposits (RD) – 6 to 7% yearly interest
- Liquid Funds (Instant Redemption Fund) – 6 to 7% yearly interest
Recurring Deposit or RD is a type of fixed deposit in which you can invest the same amount every month and at the end of a tenure ( say 1 year or 2 years ) you get an assured amount back.
And liquid fund is a type of mutual fund (debt) that invests mostly in Government securities. Most Liquid funds allow instant redemption of up to ₹50,000 or 90% of the invested amount. So you can redeem it any time and it will be credited to your linked bank account instantly. It is easily available in apps like Paytm Money, Kuvera, Groww etc.
I would suggest you avoid the Savings Bank Account route as it gives the same amount of safety & stability as the other two but gives you half the return.
Personally, I keep my emergency fund in liquid funds. To ensure more safety, diversification & liquidity I use 3 liquid funds to store my emergency fund
> Navi Liquid Fund
> Quant Liquid Fund
> Mahindra Manulife Liquid Fund
Not just these, you can choose any 2 to 3 funds depending on your personal comfort level. Also, you can automate this entire process, and I would strongly suggest you do so as it keeps you disciplined on your path to financial freedom. To automate you can start a RD with your preferred bank and turn on auto-pay so that each month automatically it deducts the specified amount and put it in the RD. Same with liquid funds – these apps have great UI and many features like Auto Pay, SIP etc.
Hope this piece was useful for you.
As always, please don’t take this as investment advice; am not a SEBI registered investment advisor. This is just a personal chat between me & you – about helping and motivating you to start your investment journey as fast and with as little money as possible.
If you have any questions, tweet them at @InvestRepeat. Also, you can join my private Telegram channel (Username: InvestRepeat).
Your man,
SIR
