Emergencies do not come announced but you can at least be financially well-prepared with an emergency fund. It can fund any emergency expense be it car repairs not covered by insurance or meeting regular expenses easily after a sudden job loss. Having an emergency fund may seems obvious yet it is a crucial aspect of finances commonly overlooked by the young starting out in their financial lives.

Why You Need an Emergency Fund

Keeps money accessible for emergencies Money earmarked solely for emergencies helps you quickly address the emergency requirements instead of spending precious time figuring out from where to organise the funds or diverting money earmarked for current or future needs. This can be crucial in early work life when the gap between expenses and take home pay tends to be less and one has limited savings.

Helps meet uninsurable expenses We have already discussed emergencies arising from damage to vehicles and job loss. Emergency funds are equally handy for meeting other emergency expenses such as hospitalisation expenses not covered by health insurance like the portion of room rent exceeding eligible amount.

Secures monthly budget Emergency expenses typically divert liquid or accessible money and disrupt the ability to meet regular expenses. Emergency funds help temporarily secure your current lifestyle. The young also need not swallow their pride and seek bail outs from family and friends. They can also help meet unplanned and unavoidable expenses like the sudden wedding of a bosom pal.

Protects investments

Emergencies often result in premature exits from investments meant for major needs like children’s higher education and retirement. In adverse market conditions premature exits typically happen at a loss. This is true for high growth investments like equities, equity mutual funds like index funds, large cap funds, mid cap mutual funds, and small cap funds besides equity-oriented hybrid funds such as balanced advantage funds. Worse after premature exits investors have lesser time to accumulate the money required. Emergency fund prevents such premature exits.

Helps avoid expensive loans

During emergencies people often end up taking expensive loans such as personal loans and credit card debt. An emergency fund helps avoid high loan repayment burden that impacts the home budget limits lifestyle expenses and investments for future needs.

Helps during life conditions and transitions

An emergency fund helps you in situations of squeeze on income like a job loss a predictable health condition for you or family member obligations such as dependent parents and siblings. It is also helpful in transitions such as new single income household just after marriage lower or no income during career transitions such as when one spouse decides to give up work for childcare on childbirth full time study sabbatical and when kickstarting own business.

How Much Emergency Fund Is Enough?

Those starting out in their careers can aim at creating an emergency fund equivalent to three months of expenses. This thumb rule can remain the same on setting up a household after marriage with a rise in expenses.

The emergency fund amount needs to be revisited and possibly revised upwards after life milestones transitions and conditions such as the birth of children aged parents and other dependents moving in. In such cases the emergency fund size can be 3-6 months of expenses.

A predictable health condition for you or any family member also calls for a higher emergency fund size depending on the expected expense. The same is true if you could face situations related to your income such a fickle job security or career transition such as a mid-career course. In such cases the emergency fund needs to be large enough to meet regular and other expenses such as EMIs and insurance premiums during the period of transition i.e. 3-6 months going up to 8 months to 1 year.

Where to Keep Your Emergency Fund

It is important to remember that easy accessibility or high liquidity not returns is the key characteristics of any parking slot for an emergency fund. At the same time you need a nuanced approach in cases where you need a relatively large emergency fund.

Immediate needs

Amounts likely to be needed immediately can be parked in jointly operated bank savings accounts. Remaining amount of the emergency fund can be parked in mutual funds such as debt mutual funds like liquid funds and ultra short-term debt funds.

Longer term needs

When your emergency fund size exceeds 6 months of expenses you could even consider parking a portion of it in arbitrage funds to take advantage of favourable equity mutual fund taxation. The capital gains are treated as those arising from equities and taxed at a lower rate compared to the tax on debt mutual funds like liquid and ultra short-term debt funds which is the income tax rate.

How to build an emergency fund

You can gradually build an emergency fund with regular mutual fund investments in debt mutual funds like liquid and ultra short-term debt funds using Systematic Investment Plan (SIP) for each investment. You can also make small investments regularly in bank recurring deposits (RD) if you plan to keep a portion of the emergency fund in an FD. Finally if you dip into the emergency fund replenish it using the SIP investment route.

As you can see an emergency fund is much more than smartly handling emergencies. Creating an emergency fund is the critical first step in establishing our finances. That is why many experts term protection from emergency funds and insurance as the foundation of our finances on which one can build the monument of wealth.