As the name suggests, an emergency fund is a necessary part of your earnings that you must keep aside to tackle emergencies. Technically, an emergency fund is a readily available source of liquid assets that can be cashed out while navigating through financial dilemmas, such as a debilitating illness, loss of a job, an expensive repair of home or car, or other unexpected circumstances such as a global pandemic.
To put it in simple words, you can fall back on in need during a crisis or unplanned circumstances a fund.. As financial planners, we advise that your emergency fund should have enough finances to sustain you for three to six months at least. However, it may seem unrealistic to some. Therefore, we are here to answer some of the most popular questions about emergency funds.
Why is an emergency fund required?
The purpose is to ensure financial security during critical circumstances. Having an emergency fund is a necessity, which acts as a shock absorber for any financial bumps that one might come across. It must be planned in a way that it meets your unanticipated financial shortfalls and creates a financial buffer that keeps you afloat in the hour of need without having to rely on loans with excessively high-interest rates or credit cards. If you are already in debt, then it becomes crucial to have an emergency fund so that you can avoid borrowing more or at least clear your previous debts before taking any more loans.
Why should the emergency fund be liquid?
The idea of these funds is to cover any unexpected expenses. Therefore, it should be ensured that these funds are parked in a liquid form. This is important because you should be able to withdraw the money when you need it without any delay. Check that you aren’t penalized in the form of an exit load or pre-withdrawal penalty, and the value of the amount invested should not go down either.
How much to save in your emergency fund?
The thumb rule of having an emergency fund is to have three to six months’ worth of your monthly income depending on your income and expenses. For example, if your monthly income is $3,000 out of which $500 are spent to meet the routine living and medical expenses, then ideally your emergency fund should be somewhere in the range of $5,000-7,000 at least.
The amount of money required for your emergency fund should be carefully evaluated, for we live uncertain times with uncertain economies, especially with a global pandemic in full force. There is no job security, and corporate loyalty only exists in theory, which puts the multitude of us in a vulnerable position to unemployment. The emergency fund should be sufficient to sustain you for some time, at least in case of unemployment.
Your emergency fund can also be divided into two categories:
- Long-term emergency funds: Here, you save for large scale emergencies like a medical emergency or unemployment. Withdrawal of this fund should abstain unless necessary, and it should be invested somewhere that allows one to earn a slightly higher rate of interest but only take a few days to liquidate.
- Short term emergency funds: It may offer low interest, but has immediate accessibility and can be liquidated at any instant, which can suffice till the time one gets access to long term emergency funds in case of extreme situations.
Where should you invest your emergency funds?
Emergencies can strike at any moment. Therefore, it is advisable to not have your entire emergency fund tied up in a long-term investment fund. Once a sufficient emergency fund is accumulated, it should not be left in the form of cash or a bank account, at least not entirely. It is wise to invest these to earn decent returns from it without compromising on the liquidity.
Spread and invest the emergency fund across short term RDs, mutual funds, and other forms of liquid funds. Two good places to park your emergency fund are money market funds and high-interest savings accounts.
How to redeem your emergency fund?
It is quintessential to check for an instant redemption facility before investing in a liquid fund to ensure that the institution where you are investing your fund allows instant redemption of the amount. Almost all liquid funds allow instant redemption of up to 90% of the invested amount, as far as liquidity of the fund is concerned. The amount is instantly credited to your linked bank account.
This way, you can enjoy quick accessibility and high returns on the amount.
Strategies to build an emergency fund
Emergency funds act as a comfortable cushion against unexpected circumstances in life and so it is essential to start early for setting it up.
Two relatively easy strategies to get started are:
- Set aside a comfortable chunk of your salary each month
Divert a portion of your monthly income to the emergency fund account. Calculate the necessary living expenses of at least three months and make that the target for your emergency fund. Once your savings reach the target, invest the extra savings for the long-term goals, and invest the entire amount to a liquid fund with high returns.
- Save your tax refund
A major mistake that we all are guilty of committing is treating our tax refund as “extra” cash and giving in to the urge of using it for discretionary purchases. Instead of spending this tax refund, it is better to save it as a contribution towards your emergency fund to lessen the burden of setting aside a chunk of your monthly income to savings
Now that you know everything you need to, it is time to set up your emergency fund and be prepared for the uncertainties of tomorrow, especially in the wake of the Covid-19 pandemic.