What is an Emergency Fund- Why Do You Need One?

byYashi DasLast Updated: February 10, 2023
What is an Emergency Fund

The term, ’emergency fund’ in itself, is indicative of its purpose, referring to the funds that you keep aside for emergencies and contingencies. You stash away a little portion of your income to accumulate earnings to help in times of financial distress. Unanticipated incidents can lead to unwanted expenses and you may run short of money at the time. Securing a part of your assets for such urgent times to deal with financial chaos and deficiency is a smart investor move.

Features that an Emergency Fund should have!

An emergency fund is a financial safety against unwarranted contingencies. You can use surplus amounts from income and tax refunds to build it. Here are a few important things that an emergency fund must have:

  1. Liquidity

It is important that emergency funds can be used during emergencies and are easily accessible. This is why liquid mutual funds are often advised as the best investment avenue for emergency funds. They have a maturity period of 91 days where you can park your money and earn higher interest than bank deposits. They are highly liquid and easily redeemable. Emergency funds should always be the ones where you can withdraw cash easily.

  1. Security

By security, we mean that the emergency funds should be created through such investments that are low-risk options. Do not invest in high-risk market-linked equities, futures, and options investing. Make sure you invest in short-term fixed-income securities and bonds that have guaranteed returns with almost negligible credit and interest risks.

  1. Separate from investments

Investments, especially in mutual funds are meant for capital appreciation that can help you beat inflation and live up to your lifestyle. Emergency funds must always be seen as a financial guard and not an asset. So, keep your investments aside from the emergency funds.

How much should Investors Save for an Emergency Fund?

Investors often wonder what is the right amount for an emergency fund that they should keep aside. How big an emergency fund should be to protect them against unwarranted predicaments? An emergency fund and its amount size depend on a lot of factors like your financial stability and lifestyle. You should plan to invest in emergency funds based on your monthly income, family size, standard of living, existing debt, medical history, etc. Experts advise that at least 3-6 months of expenses should be kept aside as an emergency fund. Some financial advisors suggest that an emergency fund should be able to keep you going for more months, about 8-12 months. Do not worry if you do not have such a fund yet, but start early to keep aside even a small amount (at least 2%) of the paycheck you receive.

Where to Invest for an Emergency Fund?

As mentioned above, emergency funds should be liquid that can be redeemed easily, and are non-volatile, so one should invest them in fixed-income securities. Reiterating the fact that liquid funds are often called emergency funds, as they allow instant redemption of up to 90% of the fund value. Other than liquid funds, a high-yielding savings account, short-term FDs, or certificate of deposits (CDs) are alternatives to invest in for building an emergency fund. However, liquid funds can get you the best interest rates and earn you returns on your fund.

Why have an Emergency Fund?

Mishaps can occur at any time, taking a toll on us, one of them being the monetary expenses. The pandemic has already taught us the lesson that emergencies can strike anytime, be it medical healthcare bills or a bout of joblessness. If we invest to create a cash reserve specifically for such unfortunate situations, it can help us prepare ourselves to meet obligatory expenses. Having an emergency fund can be useful in the following ways:

  1. An Aid for Financial Emergencies

The first and foremost advantage of an emergency fund is that it can be of great assistance during financial emergencies. Imagine running short of cash at a hospital or being broke due to unemployment. You may have to cut down on other expenses or borrow money or take some unplanned decisions to meet the requirements. You can build a safety net through an emergency fund so that you neither need to compromise your lifestyle in such situations nor take a loan or sell your assets.

  1. Saves from Bad Financial Decisions

When you do not have an emergency fund to deal with financial surprises, you may make some unwanted and rather bad decisions. You may borrow money, take unwanted loans, over-exercise your credit card, sell your property/assets, hamper your retirement funds or pull from other savings to cover the costs. One monetary shock will turn into a debt that can have a long-lasting impact where one may struggle to pay off the debt. S/he will have lesser savings and this will undermine the security for future emergencies. You can save yourself from a debt trap during a financial crisis with an emergency fund in hand.

  1. Money Management

When you develop a discipline to save up for an emergency fund, you avoid spending on a whim and save money. Also, you learn better money management by carefully segregating your expenses, savings, and investments. You will also plan your investments in a better fashion like how much for retirement, other long-term savings, and emergency funds. You can also chalk out the plans for long-term and short-term emergency funds. You will also know what are your necessary expenses and sieve out the non-essential expenditure.

  1. Reduces the Stress Level

Having an emergency fund boosts you mentally to deal with unexpected events and keeps your stress level down during financial shortfalls. When you live on a financial edge, spending more, saving less, then you find it hard to tackle emergencies and that affects your mental health. Money problems cause stress and anxiety that add up to your woes and further push you to make bad decisions to access quick cash like loans or credit cards which will come with fees, penalties, and interests.

Wrapping it up:

Emergency funds are a corpus balance that can help tackle the unforeseen financial crisis. It can prevent falling into a debt trap, mortgaging existing assets, or redeeming from future securities like retirement funds. It is important to take note of your income and net expenses as well as to calculate how much you need to invest in emergency funds. Also, these funds should not be hampered for frivolous causes. No matter how tempted you are, do not deplete them for incidental purposes but save them for real emergencies. Emergency funds should be easy to liquidate and hence, do not invest in equities or other risky assets.

Can I have an emergency fund kept in cash?
Yes, you can have an emergency fund kept in cash but it is not considered to be ideal. One, because having such a huge amount in cash at home has security issues. Secondly, it earns you no interest.
How to calculate the amount for an emergency fund?
Add up all your monthly expenses and multiply it with 6, as advisors suggest a minimum of six months of net income or at least the total expenses should be in an emergency fund.
How can I save for emergency funds?
Make a monthly commitment to saving a little amount for an emergency fund by calculating your requirement. Make use of lump sum inflow like tax refunds or office bonuses to add to the fund to fulfill the target earlier.

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