How to Build an Emergency Fund?

Updated on 24 Oct, 2023

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An emergency fund is your cushion that saves you from unforeseen expenditures or during no income days. An emergency can be a natural disaster such as an earthquake or a flood, a health problem that prevents you from working, or economic turmoil that results in job loss and income cuts. All of this is out of your control. Having an emergency fund is like ensuring that you have the finances to navigate any emergency. Emergency fund requirements are different for everyone, and thus you must create a fund that matches your needs. Let’s see how to build an emergency fund?

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How to Start Building an Emergency Fund?

Having some emergency savings on hand is critical to your overall financial well-being. An ideal amount for an emergency fund varies between six to eight months’ worth of expenses. However, this can build up to a frightening sum for many and might discourage even the most well-intentioned saver.

Saving is largely a psychological game that you can win. Even If you’re starting from scratch, consistently saving money will help you reach your target. It takes time and self-discipline.

The following steps will help you build an emergency fund:

1. Set up a target date

Setting a deadline for yourself can help you achieve your goal faster. Set a deadline for creating your emergency fund goal based on your current financial situation. Three months, six months, or even a year may suffice. However, the sooner you begin, the easier it will be to raise the necessary finances.

2. Divert some of your existing assets

You may already have some assets available to contribute to your emergency fund. It could be excess funds in your savings accounts or other unrelated fixed deposits. You can set aside a portion of that sum for your emergency fund. Even if you don’t have any existing savings, do not worry. Starting now and consistently contributing towards the fund will help you create the desired corpus soon.

3. Identify monthly investment amount

Estimate how much you need to save monthly to create the emergency fund. For this, first list down your income and expenses. Then, see how much disposable income is available for you to build the emergency fund.

Also, you can identify a monthly commitment towards your fund based on your shortfall figure. In other words, it is the amount by which your requirement exceeds the cash you have. For instance, if your emergency fund requirement is INR 5 lakh. You already have INR 2 lakh in your savings account. Then, you can use the amount in your savings account and start saving more to complete the fund requirement.

A simple technique to get the figure is to divide it into monthly instalments. If you’ve set a one-year goal, you’ll need to set away INR 25,000 per month (INR 3 lakhs/ 12 months). Until you achieve your objective, you need to be highly focused and should not compromise.

4. Trim your expenses

Reducing non-essential spending will enable you to reach your savings goals faster and possibly even increase your monthly allocations. You may compromise on your luxury purchases and prioritise your expenses. For example, rather than dining out frequently, limit yourself to one or two outings per month, minimise non-discretionary online purchasing etc. These small lifestyle adjustments will help you build an emergency fund faster. You can always postpone your expenses and enjoy them once you have your emergency fund.

5. Create a separate account

When you have some extra money in your savings account, you are always tempted to spend. Alternatively, you may use this extra money to build your emergency fund. You can have a separate account for your emergency fund. Keep transferring your monthly contributions and excess funds to this account. Ideally, park your emergency funds in short term debt funds such as liquid mutual funds.

6. Choose the right investments

Selecting the right investment option when investing to build an emergency fund is critical. Ideally, your emergency fund must be easily accessible and provide a greater rate of return on your savings. Furthermore, it should protect you from market changes and be stable and reliable. Finally, you must choose safe investment vehicles such as fixed deposits and debt mutual funds like liquid funds, which offer steadier returns, better flexibility, and liquidity.

7. Automate your investments

When building an emergency fund, it’s preferable to schedule payments from your primary account so that a portion of your income is diverted to the fund. However, automating your investments will eliminate the need to remember to allocate funds to emergencies regularly.

8. Top-up the fund with any lump sum cash flows

We often get year-end bonuses, tax refunds, or cash gifts. Use this money to build your emergency fund faster. Set aside a small amount and invest the remaining in your emergency fund. Adding unexpected income can accelerate your progress toward building your emergency fund.

9. Regularly monitor your progress

Establish a system for monitoring your savings regularly. Whether it’s an automatic notification to know your account balance or a rolling total of your contributions. Keeping track of your progress can provide a sense of accomplishment and motivate you to continue.

10. Don’t over-save

Avoid devoting an excessive amount of your savings to your emergency fund. By definition, an emergency fund is a cash fund that is readily available in emergencies. That indicates you’re most likely holding the funds in a low-yield vehicle, such as a fixed deposit or debt fund with a low-interest rate. Simply for that reason, once you’ve attained your corpus requirement, you should discontinue contributions to that account.

Begin investing your funds in assets that give you higher returns and help you achieve your long-term goals, like retirement, child’s education, marriage, etc.

11. Use the corpus only in case of emergencies

The purpose of an emergency fund is to offer you a cushion to fall back on in case of unforeseen events or situations. If you can meet the cost of an unplanned expense with your income, do not bother to disturb your emergency fund. While on the other hand, if you have an expense that requires funds from your emergency fund, do not hesitate to use it. You are your best judge. Analyse the situation well, and do not use the funds for unnecessary expenses, but save them for a rainy day.

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