How and why to create an emergency fund

We all need to deal with emergencies at some point or the other whether it's a job loss, a medical emergency in the family or a car breakdown. An emergency fund is a lifeguard that helps you deal with unexpected expenditures without adding more to the existing trauma of dealing with an emergency situation.

Investmentyogi.com explains the what, how and why of emergency funds.

What is an emergency fund?

An emergency fund is an easily accessible stash of money for use only in case of an emergency. Establishing an emergency savings account is vital in good times and in bad. The purpose of the fund is to stock away three to six months of living expenses. But this money could also be used when you are staring at major, unplanned expenses such as a car breakdown or a leaky roof.

What's important is that you put the money away consistently, and then tap it only for true emergencies. The success of any long-term savings plan depends less on the rate of return and more on consistently putting money away and leaving it there.

Why do you need an emergency fund?

Do you really need to ask? Here are some possible scenarios which occur very-very commonly:

• Medical emergencies for self, parents, children
• Loss of job especially in the recent economic downturn
• Bad business cycle for self employed people
• Unexpected expenses like breakdown of a refrigerator, car etc.

How much is enough?

Though personal finance experts agree emergency funds are necessary, there is no consensus on how much is enough. Some say you need save a year's salary. Others believe Rs 10,000 is sufficient. Most advice tends to fall somewhere in the middle.

How much do you really need?

Three to six months of living expenses are most common and reasonable. For a double-income family where one salary is sufficient to cover most necessary expenses, you could get by with lesser amount or if you are self-employed with wildly varying income a higher emergency fund may be needed.

How to create an emergency fund (if you do not already have it)?

The reason most people don't have any emergency money in the bank is that they have what they think is an emergency every month... a real emergency is something that threatens your survival, not just your desire to be comfortable.

Creating an emergency fund is as simple as putting at-least 5 to 10 per cent of your income aside every month and not touching it other than for true emergency. Here are some tips:

• Get 5 to 10 per cent (more if possible) of your income transferred to a different account before you are able to put your hands on it.
• Move any surplus like gift, bonus etc into that account right away.
• Collect your pocket change and put it in an emergency piggy bank every day. Then at the end of the month, put it in your emergency account.
• Create a budget for your household to see if there are any unnecessary expenses which can be eliminated. Put the savings in an emergency fund.
• Make the account inaccessible, don't a carry checkbook or ATM card for that account.

Where to invest it?

Not earning interest on your emergency money is almost as bad as stuffing it in your mattress. The interest you earn on the emergency fund will again increase your emergency fund. There are two aspects about investing in emergency funds:

• Investing the money while you are in the process of building your emergency fund.
• Maintaining the optimal balance of high returns and liquidity when the money is already available.
• Here are some possible options you could use. Choose a combination of these strategies based on your needs:
• Make sure you have a certain amount available in your savings account which is immediately available.
• Recurring deposits every month are a very good way of building an emergency fund.
• Availability of credit card limit is very useful in times of need as long as you have resources to pay-off the balances quickly.
• Linked FDs are a new innovative product few banks have been offering. Surplus in savings accounts gets automatically transferred to FDs (to get higher rate of return) and when withdrawn FDs are liquidated seamlessly and you get the amount. So you get the liquidity of a savings account with high returns of fixed deposits.
• Fixed deposits allow facility of loan which can be used if little time remains for maturity. If significant time remains, breaking an FD is a better option. FDs are useful when possibility of funds being utilised is very low.

Fixed deposit ladders give you double benefit of high rate of returns with high liquidity as well. Here is how it works:

• You go to the bank with Rs 30,000 and buy a Rs 10,000 three-month FD, a Rs 10,000 six-month FD and a Rs 10,000 nine-month FD.
• Once the three-month FD matures, you put it into nine-month FD.
• So your money is available every three months but you are getting returns of a nine-month FD.
• Duration and amount can be customised according to your needs and interest rates.

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