Building an emergency fund is considered a major step towards financial stability. Life is unpredictable and even well-planned budgets can be derailed due to unexpected financial hardships, such as medical emergencies or job loss. Without a safety net, these situations usually force people into debt and make them compromise with their long-term financial goals.
The key to building the right emergency fund depends on various factors. It needs to suit your personal risk level and monthly budget. A person with a stable job and dual income might need a smaller emergency corpus compared to a freelancer with irregular earnings or a family relying on a single paycheck.
While building an emergency fund, it's advisable to take into account your monthly expenses and future financial needs. An assessment of your risk profile and essential monthly expenses could be helpful in computing the right amount for your emergency fund.
What Is An Emergency Fund?
In simple terms, the real purpose of having an emergency fund is to cover essential expenses during unexpected financial shocks.
An emergency fund should be able to support regular expenses like utilities, groceries, insurance, transportation, healthcare and rent during a financial crisis. Notably, this is not meant to cover vacations, shopping, lifestyle spending or planned expenditures.
Assessing Risk Level
Experts often advise building an emergency fund that should be enough to support your monthly budget for three to six months. However, the size of the emergency fund should be based on risk factors and financial needs.
Low Risk (3 months): This is mainly for single individuals having low EMIs and strong job security or for families with dual income household. For them, three months are considered sufficient, since this is the bare minimum safety cushion.
Moderate Risk (6 months): It is often recommended for single-income households, freelancers or contract workers and those with moderate debt. Usually, this is recommended for most working families and covers rent/EMI, groceries, school fees and insurance.
Also Read: IRDAI Member Urges Insurers To Cut Costs And Fix Mis-selling For Affordability
High Risk (9-12 months): An emergency fund to cover expenses over 9 to 12 months is crucial for single earners, freelancers and business owners, since economic downturns hit variable income earners harder. It is important to have an emergency fund to cover up to 12 months for individuals with high medical costs or dependent family members.
Emergency Fund: What It Covers?
It is mainly for covering all the essential expenses, keeping aside lifestyle splurges.
Among these include rent/EMI, food, utilities, insurance premiums, school fees, medical costs and other things. It does not cover vacations and luxury shopping.
How To Build It?
Investors should start with small amounts and stay consistent. Prior to that, they must calculate the monthly expenses first to reach the right estimate for an emergency fund.
Also Read: Cashback Or Rewards Points: Which Credit Card Benefit Is Better For Savings?
It's advisable to set up an auto transfer to a separate savings or liquid fund account. This automates savings while allowing you to manage your money within a pre-determined budget without affecting savings.
Essential Business Intelligence, Continuous LIVE TV, Sharp Market Insights, Practical Personal Finance Advice and Latest Stories — On NDTV Profit.