Here's Your Step-by-step Guide To Building An Adequate Emergency Fund

Have you ever seen a building under construction? Of course, you must have. But have you ever wondered what would happen to that building if its foundation turned out to be weak? The building is likely to collapse someday, sooner or later, especially in case of an adverse calamity like an earthquake, right?

Now imagine not having a solid foundation for your finances. A single financial exigency can wipe out your lifelong savings, and even make you sit onto a pile of debt. Sounds scary, right?

That is exactly why it's advisable to always have an adequate emergency fund in place, which is also termed a contingency or rainy day fund. But before we jump onto the steps of building an emergency fund, let's first understand what it is and why it is not an option but a necessity.

What Is An Emergency Fund?

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An emergency fund, also known as a rainy day fund or contingency fund, is a portion of your savings set aside to deal with unforeseen financial difficulties in life. It acts as a cushion to help you tackle those emergencies in your financial life that are capable of temporarily hindering your regular inflow of income.

Such financial exigencies can be in the form of a sudden job loss, severe illness, disability, or a significant pay cut. In all such adverse events in financial life, having an emergency fund is what can rescue you by helping you carry on with your recurring monthly expenses.

Also Read; How To Be Financially Prepared Amid Mass Layoff Wave

How Can You Create An Emergency Fund?

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Now that you have understood the importance of an emergency fund, it's easier to chalk out the steps to take next.

Step 1

To build your emergency fund, the first step is to figure out what are your monthly and recurring expenses.

Your mandatory and recurring monthly expenses generally include:

Fixed expenses: Rent/maintenance, EMI payment, insurance premiums, children¡¯s school fees, SIP (if any), etc.

Variable expenses: Grocery, medicines, electricity, gas, travel, phone bills, internet, and other incidentals.

Keep in mind that your fixed and variable expenses which are mandatory and recurring in nature will form your emergency fund ultimately.

So, for instance, let's take an example. If your monthly rent is Rs 15,000, utility bills (such as water, electricity, and grocery bills) are Rs 20,000, existing loan EMIs are Rs 15,000, and ongoing SIPs are Rs 10,000, your monthly recurring expenses are Rs 60,000. With these expenses, your emergency fund should amount to at least six times this amount, i.e., Rs 3.6 lakh. This amount should remain untouched until a financial emergency necessitates the need to use it.

It goes without saying that spending on shopping like clothing, dining out, subscription to OTT platforms, gym, etc. are usually left out of the gamut of an emergency corpus.

But you can choose to include whatever else you feel is a mandatory or recurring expense for you, buying or paying for which shouldn't be hampered whenever a financial emergency arises.

Also Read: 5 Signs That You Are Not Financially Prepared If A Recession Strikes

Step 2

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The next step after you chalk out your expenses, is to estimate the emergency fund¡¯s size. While there is no hard and fast rule, it is usually advisable to have an emergency fund with an amount equal to at least six months of your recurring monthly expenses. The size can be even bigger, such as 9¨C12 times the monthly expenses if you can maintain that size. After all, the bigger, the better!

Step 3

Last but not least, park the rainy day fund separately. Avoid mixing the emergency fund amount with your usual bank account that you tend to use on a regular basis, as this can make it difficult to keep the emergency fund amount untouched.

So, where to park it? As emergencies can strike at any time, your emergency fund should be kept in a liquid instrument like savings accounts with high-interest rates (like small finance banks and some private sector banks) or liquid funds (a category of debt mutual funds).

You may keep your emergency fund in high-yielding bank FD too, as nowadays, one can not only open but also close/redeem FD online through mobile banking or net banking itself quickly.

Also Read: Health Insurance Myths Debunked

When Is The 'Right Time' To Build An Emergency Fund?

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As soon as possible. That's it. There is no right time for which you need to wait. Start building your emergency fund right away, if you haven't done so yet. Don't wait for a financial exigency to happen and harm your finances in the absence of the rainy day fund.

Another thing to keep in mind is that creating the emergency fund is not a one-time task only. Once you have created your emergency fund as per your current expenses, you need to revisit the fund size and add or minus any expense if needed, as per the changes in your monthly/recurring expenses in different stages of life. Ideally, avoid trimming down your emergency fund and try and keep a big one as much as possible. After all, there is no harm in having a bigger emergency kitty rather than an inadequate one, right?

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