Why do we need an Emergency Fund and how to build it?

We’ve all had unanticipated financial problems, such as an unexpected medical cost, a malfunctioning appliance, a loss of income, or even a damaged car. These unforeseen costs, whether large or small, can feel as though they have come at the worst possible time. Setting up a separate savings or emergency fund is an important method to safeguard yourself from these unanticipated costs.

Most personal financial gurus believe that the first thing you should do after fulfilling basic necessities – is to create an ’emergency fund’.

An emergency fund, sometimes known as a “rainy day fund,” is a cash reserve set up exclusively for unforeseen expenditures. It cannot be used to purchase a new car. It is not to be utilised for an abroad trip. It should not be utilised to decorate your home’s interior. It is only to be used in an emergency, such as medical bills or job loss. In essence, emergency savings can be utilised to cover large or minor unanticipated expenses or payments that are not typical of your normal monthly expenses and spending.

According to research, those who fail to rebound from a financial panic have fewer reserves to assist defend against any future disaster. They may count on credit cards or loans, which can result to more debt that is often more difficult to repay. This may prompt individuals to withdraw monies from other investments, such as retirement accounts, to pay these unforeseen expenses.

How much to save in an Emergency Fund:

The amount you should have in an emergency savings fund is determined on your personal circumstances. Although personal finance professionals agree that emergency reserves are required, there is no agreement on how much is sufficient. However, the general consensus is that you should set aside at least 6 months of living costs. In addition to this money, experts recommend having appropriate insurance that will cover any major medical emergency. It should also be mentioned that the six months of living expenditures should include any mortgage payments or loan EMI amounts.

You will sleep better if you have six months of living costs saved up. It’s comforting to know that even if you lose your job, you’ll be fine.

How to start an Emergency Fund:

It is quite simple to establish an emergency fund. As a general guide, you may build an emergency fund by following these four steps:

1. Choose a Bank – Choose a safe haven bank that offers a good savings rate and is also a secure place to keep your money. You may be familiar with many major banks in your neighbourhood. Begin your savings account with a bank that has a great reputation and that you have known for a long time.

2. Maintain a close watch on debt – If you remain in debt, it’s usually advisable not to put too much money aside in savings. Perhaps you should set away a modest amount of money as savings, maybe 5% of your monthly salary or so (though this could differ from person to person), to this Emergency fund savings account, but the remainder of your money should indeed be devoted to debt reduction.

3. Save even more – As your debt decreases and you have more financial control, increase your emergency savings more responsibly. Choose a goal for yourself, such as 6 months, 9 months, or 12 months of living expenditures. However, the basic minimum should be 6 months of living expenditures. This may appear to be a large sum of money to you, but if something bad happened, it would let you subsist for a prolonged period.

4. Resist the impulse to splurge – When you have a large sum of money lying in your bank account, it might be enticing to squander it on anything else. Resist the temptation. If you don’t use your rainy day fund for emergencies, you’re defeating the objective of having one in the first place. If you believe you are not strict enough not to spend the money for other purposes, it is best to put your emergency fund somewhere that is not easily accessible. For instance, keep the cash in a new savings account, and do not sign up for online banking for that account. Have a basic debit card for this account but put it in a place that you do not reach frequently. By doing so, you may avoid utilizing that account for ordinary spending.

What are the savings strategies to follow in creating this Emergency fund:

There are several methods for getting your savings launched. These tactics may be used in a variety of scenarios, such as if you have a restricted ability to save or if your income fluctuates or any other such scenarios.

Create a savings habit:

Establishing a savings account of any kind is simpler when you can regularly save money. Setting a financial goal might help you stay focused. Creating an emergency fund may be the attainable objective that keeps you on course, particularly when you’re just starting. Not only should you set some money aside for saves, but you should also keep track of your savings on a regular basis. Whether it’s an automated alert of your account balance or keeping a detailed record of your contributions, tracking your progress may provide satisfaction and incentive to keep going. If you’re keeping to your savings plan, don’t pass up the chance to celebrate your success. If you meet your savings goal, reward yourself, which will drive you to establish your next one.

Manage your Fund Flow:

Your cash flow is simply the time of when your money comes in (your earnings) and goes out (your costs). If your timing is incorrect, you may find yourself short at the end of the month, but if you regularly watch your fund flow, you’ll see possibilities to alter your expenditure and savings. For example, you may be able to negotiate with your creditors – such as your homeowner, public utilities, or credit card issuers – to alter the due dates for your bills, or you can use the first few weeks of your salary to put a little extra funds into savings, when you have extra funds in your account. This is a vital stage in money management, irrespective of whether you live paycheck to paycheck or expend more than what your budget permits.

Take advantage of small financial windfalls to save:

There may also be moments during the year when you receive an inflow of funds. For example, it may be a bonus or incentive from your work, or it could be a monetary present from friends and family for a holiday or birthday. While it may be alluring to squander it, saving all or a part of it might help you swiftly establish an emergency fund.

Automate your savings:

Set up a mechanism for making continuous payments to your savings, such as a monthly automatic recurring deposit. Saving automatically is one of the simplest methods to make your savings constant so that you can see them grow over time. However, you should keep track of your balances to avoid incurring overdraft penalties if there is insufficient money in your salary account at the point of the automated transfer to the emergency savings account. Think about setting up automated alerts or calendar reminders to review your balance well before automatic transfer to help you keep informed. This method is beneficial for individuals who have a stable monthly income. You may also specify how much and how frequently money should be sent between accounts. If your circumstances or income change, you may always modify the monthly transfer amount. The conventional advice is that if your pay grows, you should raise your monthly transfer to the emergency savings account proportionally. This will guarantee that you obtain your emergency corpus as soon as possible.

Where should you keep this Emergency Fund:

The positioning of your emergency fund is determined by your circumstances. Because the aim of this fund is to cover unforeseen costs, you should ensure that the fund is secure, accessible, and liquid. You should be able to take out the funds whenever and however you require them. Simultaneously, you must avoid being fined in the form of an exit load or a pre-withdrawal charge.

A bank savings account is often regarded as one of the safest locations to save your emergency money. It may also make sense to create a separate savings account where you may hold and manage these emergency funds, and this account should be free of any other operations.

Some financial experts note that, while an emergency fund ought to be liquid, it shouldn’t be accessed frequently. As a result, invest it in such a way that you may generate acceptable returns while maintaining liquidity. The best approach would be to distribute the emergency cash across liquid assets, short-term RDs, and debt mutual funds. By doing this, the money saved as an emergency fund does not lose value owing to inflation.

When to use your Emergency Savings?

But here’s an intriguing question: how can you judge what’s an emergency and what’s not?

A trip to a foreign country is not an emergency and should not be paid for with this emergency fund. It is not a necessity to get a new pair of shoes from this fund. However, if your car is damaged and the cost of restoration exceeds the amount of car insurance purchased, this is an emergency.

If someone in your family becomes ill and their medical bills are not covered by their health insurance, such charges are considered an emergency. Other crises, such as house repairs due to a natural catastrophe or fire, losing your present job and having to look for a new employment again in another 2 to 3 months, and so on, are examples of emergency scenarios in which you will want your Emergency fund.

However, there may be certain costs for which you are unsure whether they are emergency or not. Hence the crucial point is to select for yourself what your emergency fund can and cannot be used for. However, once you’ve made your choice, adhere to it.

Conclusion:

An emergency fund is a necessary reserve that you must set up to deal with crises. It is a fund on which you may rely in times of disaster or for sudden and unforeseen events. It might be upsetting to see a significant sum of money lying idle in an account for months (or years). However, if a calamity hits you or your family, an emergency fund can assist you in avoiding financial ruin as well.

According to studies, persons who do not have an emergency fund are more prone to acquire debt. Your emergency fund serves as self-insurance, protecting you from minor and major calamities. If you have a cash reserve, a single unforeseen incident will not disrupt your financial objectives.