How to build an emergency fund?
Building an emergency fund is important to have good financial health and its vitality can be understood by how Capt. Edward A. Murphy Jr. laid down Murphy's Law: “Anything that can go wrong will go wrong.”
Murphy’s Law is a caveat to our decisions in life. It teaches us to be prepared for the worst as life can be unpredictable. The COVID-19 pandemic and its effect on the global economy have greatly highlighted the need for building an emergency fund and be prepared for the worst.
An emergency fund will prepare you for anything that may be thrown your way and be your surety for uncompromised financial health. So, here is how to start building an emergency fund.
Getting the figures right:
The first step is to figure out how much money you should put in the emergency fund. We all have different needs and in light of this, the size of your emergency fund should be in consideration of your income, lifestyle, dependents, and debt.
Ideally, an emergency fund should be enough to cover your essential expenditure for at least three months. This means that you should be able to live off your emergency fund for 3 months with 0 income. This part of the fund is the long-term fund.
The other part of your fund is to aid you in realizing any abrupt emergent expenses that are not covered by insurance. This is called a short-term fund of a lump-sum amount which should be replenished after every use.
Where to park your fund and how:
After you have an approximate idea of how much money you will require in case of an emergency, it is time to cut back on unnecessary expenses to start building the emergency fund. It is, therefore, helpful to set a monthly goal and keep it in a separate bank account.
An independent bank account will keep away the temptations to fritter your efforts. When looking for a savings account to store your emergency fund, the main factor to be considered should be a high-interest rate.
Managing the emergency fund - Investing:
After you have gathered a considerable amount in your account, you will feel that the money is simply sitting in the account when, instead, it can be used for investment.
However, before you decide to invest your emergency funds, you must remember the objective of building an emergency fund, which is accessibility to funds in case of an emergency. This calls for liquidity, i.e., the ability to have or convert your money in cash.
Accordingly, you can manage your fund in a 15:15:70 ratio. This ratio allows you to keep 15% of your funds in cash with absolute liquidity. This can be the short-term part of your emergency fund. The next 15% can be parked in a secure savings account where you can earn interest over time. The rest of the 70% can be used for investing.
Investing your emergency fund is an important step to not let the money lose its value by inflation. However, you must consider only those investments that are zero-to-low risk. This is because your emergency fund is not the capital you can afford to lose.
Managing the emergency fund - Precautions:
Another aspect of managing your emergency fund is to be cautious of impulses to use it to take a vacation or pay the down payment of a loan or any other non-emergency expenses.
Mindful use of the fund only for true emergencies is a necessary part of managing your fund. The emergency fund may seem a futile exercise, especially when you will see your funds not coming in use for years.
But, not having to turn to an emergency fund is a real blessing. If and when a rainy day comes, your future self will thank you for keeping this money aside.
Building an emergency fund is not an overnight task. It is a gradual process and requires you to set aside a part of your income every month for your fund to grow. Concurring to the factors mentioned above, building an emergency fund can be summarised in the following three steps:
Step 1: Making a plan for an emergency fund
Step 2: Building your emergency fund by putting the plan in action
Step 3: Managing the emergency fund to beat inflation
A fast way to build an emergency fund is knowing how to cut back on expenses. Your emergency fund is your insurance for a financially secure and stable future and it will allow you to minimize the shocks of any catastrophe.
Frequently Asked Questions
1. How much money should you have in an emergency fund?
- Experts suggest that you should have money to live for at least 3 months to even 6 months in case of loss of income.
2. How do you create an emergency fund?
- Making a plan for an emergency fund
- Building your emergency fund by putting the plan in action
- Managing the emergency fund to beat inflation
3. What are examples of emergency expenses?
- Home repair
- Loss of job
- Moving expenses
- Car repairs
- Medical emergency
4. How long does it take to build an emergency fund?
- Since the size of your emergency fund is in proportion to your income, it should not take more than 6 to 12 months to build a full-fledged emergency fund.
5. How do I calculate my emergency Fund?
- Emergency funds are calculated on a personal basis. The factors to be considered for calculating emergency funds are income, lifestyle, dependents, and debt.
6. Is an emergency fund the same as savings?
- An emergency fund can be best understood as a subset of savings. In other words, emergency funds are a type of savings that is done especially for unexpected expenses due to an emergency. On the other hand, savings can be done for any purpose like vacation, college fees, investment, or wedding.
7. Should I Invest my Emergency Fund?
- Yes. Emergency funds must be invested to counter the effects of inflation on the money. The money sitting in a bank account will only lose its value. The money from an emergency fund must only be invested in low-risk investments.
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