The Importance of an Emergency Fund: Protect Your Finances

An emergency fund is an amount of money kept aside to counter unforeseen and unexpected urgent expenses.

An emergency fund is often considered insurance against:

1. Sudden medical emergencies
2. Sudden business losses/job loss
3. Family emergencies
4. Calamities of a natural or manmade type
5. Other contingencies

It’s not the money kept aside to enjoy life or luxury, but only to protect yourself and your loved ones from sudden financial shocks.

Is it necessary to keep an emergency fund?

Yes! Absolutely. Life is unpredictable. Even people with stable jobs and incomes face financial problems many times in their lives. Without the emergency fund, you would have to rely on high-interest credit cards, personal loans, or borrowing from relatives or friends. All these come at a higher cost or sometimes give you stress; you might lose your long-term wealth by selling your investments at the wrong time.

The emergency fund helps you avoid high-interest debt, stay invested when you are already suffering losses, maintain peace of mind, and protect your long-term goals.

How much emergency fund do you need?

Though the ideal size of your emergency fund depends largely on your lifestyle, income certainty, and responsibilities, you can use a rule of thumb:

1. If you are salaried, you can have 6 months of expenses as your emergency fund.
2. If you are self-employed, 9-12 months of expenses as an emergency fund is considered sufficient.

For example, if you are salaried and your monthly family expenses are about 20,000/-, then your emergency fund shall be:

20,000/- * 6 = 120,000/-

If you are salaried, it should be 20,000/- * 9 = 180,000/-

It will include the necessary EMIs, house rent, utilities, groceries, basic travel, fuel, insurance premiums, mobile recharges, etc., and no luxury expense is part of it.

Where to park this money?

As the name suggests, it should be available to you in emergencies. So you can’t put it into volatile instruments like stocks, mutual funds, crypto, etc. Market ups and downs can reduce your money when you need it the most.

It must always be safe, easily accessible, and low risk. The best places are savings accounts, online fixed deposits, auto sweep deposits, etc. Maybe part of it should be so handy that it is kept in cash.

This money need not earn interest or gains. It needs to be very liquid.

How to build an Emergency Fund

1. Enlist all your essential expenses.
2. Set a target amount by multiplying the expense by 6 or 9 months as per your requirements.
3. Start accumulating the targeted fund. Usually, a small monthly saving of about 10% of your monthly income as a start is a game changer.
4. Automate your saving by setting up a standing instruction to a separate account right after you get your salary credited.
5. Be consistent until you reach your Emergency Fund.

Common mistakes to avoid

1. Using your emergency fund for non-emergencies, festivals, luxury, shopping, enjoyment, etc.
2. Not replenishing it after using it.
3. Chasing high returns.
4. Keeping money locked in some instrument with a lock-in period.

Summary

An emergency fund is a financial safety net set aside for unexpected expenses, such as medical emergencies, job loss, family crises, and natural disasters. It is essential to maintain an emergency fund to avoid high-interest debt, stay invested during financial setbacks, and protect long-term goals.

The recommended size for an emergency fund is typically six months’ worth of expenses for salaried individuals and nine to twelve months for self-employed individuals. This fund should be kept in safe, easily accessible, low-risk accounts like savings accounts or fixed deposits, as it must be liquid for emergencies.

To build an emergency fund, individuals should list essential expenses, set a target amount, save consistently, and automate savings. Common mistakes to avoid include using the fund for non-emergencies, failing to replenish it after use, chasing high returns, and locking money in long-term investments.