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Emergency Fund – What is It, How to Build It & Why It’s Essential?

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Life has a way of bowling bouncers when we least expect them. We’ve all been there – whether there’s a sudden medical emergency, costly car repair, or a loss of a job, unexpected expenses like these that crop up from time to time challenge our financial stability and leave us scrambling for solutions. Well, this is where an Emergency Fund comes in handy. An emergency fund is your perfect hook shot in the face of these nasty bouncers. In this blog, let us explore everything you need to know about emergency funds – what they are, why they’re important, and how you can build your own emergency fund so that during unexpected times you always land on your feet. 

What is an Emergency Fund?

An Emergency Fund, as the name implies, is a financial safety net set aside for emergency or unforeseen situations. When you are crafting your budget, you typically account for routine expenses like rent, mortgage, groceries, utility bills, entertainment, etc. However, the budget doesn’t anticipate potential home or car repairs, unexpected medical bills, and other unforeseen expenditures that may arise in a given month. That is where the idea of having an emergency fund becomes important. Rather than allocating funds for specific unplanned situations in your budget, you proactively set aside a portion of your income as savings and create a dedicated cash reserve. This emergency fund serves as an important component of your overall financial planning and provides you with a sense of security. You’ll be at peace knowing that you can weather financial storms without derailing your long-term goals.

How to Build Emergency Fund?

Building your ideal emergency fund can take some time. Here are some steps you can take to get started on your savings:

Step 1: Start by setting realistic goals – 

Determine how much you want to save. Everyone’s financial situation is unique so you have to set a specific goal that is based on your circumstances and risk tolerance. Having an achievable goal not only helps you stay on track but also helps you stay motivated. A common rule of thumb is to aim for three to six months’ worth of living expenses. 

Step 2: Create a budget – 

Know how much your total income is and all your expenses, and divide your expenses into essential and non-essential categories. The savings are going to come from the cutbacks in the non-essential expenses. Deposit this money straight into your emergency fund. This process of creating and sticking to a budget demands discipline on your part and will help you stay focused on your goal.

Step 3: Open a Separate Account for emergencies –  

Your emergency fund should be kept in a different account from your regular savings account. When you open this dedicated account make sure you have easy access to it as an emergency demands urgent action. A separate account also means that you will not be tempted to use the money in your regular savings account.

Step 4: Make consistent contributions – 

As stated earlier, building an emergency fund is a gradual process so you need to be consistent with your deposits. It’s not a problem even if the deposits are small initially but make sure they’re regular.

Step 5: Regularly review and adjust your progress – 

As financial situations are dynamic you should periodically assess them and adjust your emergency fund goals accordingly. As you watch your fund grow it will also bring you a sense of satisfaction and motivate you to keep going.

Also Read: Importance of Financial Planning

Importance of An Emergency Fund

It’s important to build an Emergency Fund as a lack of savings means even a small financial hiccup can throw you off and it can also snowball into debt. Let’s take an example. The memories of the COVID pandemic are still fresh in our minds. During that time many people lost their incomes or saw their salaries reduced. On top of that medical bills kept piling up. It was quite a tough time for everyone, financially or otherwise. While it’s almost impossible to foresee events such as a pandemic, those who prepared for uncertain times beforehand were able to comfortably sail through with way less stress. 

So let us take a look at how preparing by building an emergency can make a difference:

  • When you know you have a fund that is dedicated especially to emergencies, it brings you a sense of peace and reassurance.
  • If you have no dedicated savings fund to pull cash from in your time of need, you can be forced to take loans or pay through credit. This can lead you into a cycle of debt which can adversely impact your long-term and short-term goals. Having an emergency fund means you don’t have to fall under the burden of debt.
  • It plays an important role in risk management and investment planning as well. Let’s say you invest through a Systematic Investment Plan or SIP. In case you have to urgently pay an unexpected medical bill in a given month, you won’t have to stop your SIP installment. Instead, you can dip into your emergency fund to pay the bills thus protecting your investment.
  • An emergency fund is also very important and allows you to stay the course with your investment strategy. You won’t have to prematurely dip into your investments and will avoid disruptions caused by unplanned withdrawals.

How Much Emergency Fund Is Required?

As we said before, you should aim for three to six months’ worth of living expenses, but remember that this is a general guideline. Everyone has different lifestyles, income levels, wants, and needs so the ideal amount you should have in your emergency fund will also be different. If you have a stable monthly income things become much easier, but if you are a small business owner you can consider building a larger reserve, potentially exceeding the six-month mark, to account for the additional uncertainties that come with entrepreneurship.

There are two kinds of emergency funds:

  1. Short-term emergency fund – This fund is used to handle situations that are immediate and short-lived, such as car repairs, or a minor medical treatment. 
  1. Long-term emergency fund – This fund is used as a safety net for situations that are longer and more significant, such as a medical problem that requires extensive treatment or a sudden loss of income. It holds a much larger reserve than a short-term fund and can sustain for a longer duration. The purpose of this fund is to make things stable in times of major disruption in life.

One can maintain both of these funds to ensure more stability and maintain a high level of preparedness. Make sure this money is easily accessible. If you’re investing rather than using a savings account, go for assets with high liquidity and low risk. For the most part, a long-term emergency fund remains untouched so you can consider an account that offers a higher interest than a regular savings account.

Conclusion

Think of financial planning as a long drive and your emergency fund as your spare tyre in the trunk. You may not have to use it but when you do need it, you’ll be glad it’s there. It is your trusty companion that will provide stability in times of uncertainty, as well as peace of mind. As the saying goes, “By failing to prepare, you are preparing to fail.” A well-built emergency fund is the embodiment of this wisdom and ensures that you are prepared for the unexpected twists and turns that life will inevitably bring. You can consider consulting with a financial planner to tailor your emergency fund strategy according to your unique circumstances and make your financial plan stronger and more resilient.