Build emergency fund of six months' expenses

We make plans for every stage of our lives, a new home, a new car, marriage, exotic holidays, our children's education and our retirement. We even do our best to combat inflation with a well-strategised investment plan. However, everything in life cannot be planned. Situations such as illnesses, financial crises, accidents and deaths of loved ones are a few examples of unplanned circumstances. While these events are emotionally draining, they can potentially drain your savings and sometimes even affect your ability to go to work.

While we wish that no one faces such untoward events, everyone should plan for them as there is a way to stay ahead of these unexpected emergencies. If you build an emergency fund, you will have a cushion when life delivers a blow. The most logical question is if we have no details of the emergency, how would we save for it? The following guidelines can help you shield yourself and your family from financial devastation.

How do you begin planning?

First, take stock of all your monthly living expenses – rent, utilities, food, fees, insurance, loan repayment(s), transportation and personal expenses. Next, take stock of all your income – salary, interest payments, bonus, etc. Once you calculate your income and expenses, you can start building your emergency fund.

How much do you save?

It is advisable to build an emergency fund equivalent to five to six months' of your expenses. The rationale being that during an emergency, you can cover all the mandatory monthly expenses until you get back on your feet. Make a savings budget by setting aside a fixed amount of your monthly income and manage your expenses from the balance account. If you get a bonus, invest a part of it towards the emergency fund, ergo easing the burden on your cash flows and expediting the savings process.

How do you invest?

You can start building the emergency fund by diverting a part of your monthly surplus and invest it appropriately. While selecting investment instruments for the emergency corpus, keep in mind that you need it to be safe and easily accessible. Therefore, invest in low risk and liquid investments, even though the returns on liquid investments may not be as high. Savings bank account and liquid mutual funds are both good options for this purpose. It is important to take into account that liquid and ultra-short term mutual funds are more tax efficient and thus it is prudent to park a large part of your corpus in the same.

What are the other factors?

The responsibility of your emergency fund does not end with savings. You should review your emergency needs at regular intervals, as they may evolve over time due to lifestyle changes or other factors. Furthermore, factors such as financial stability, age, health, job security, number of earning members and the number of dependents in the family. If you are a business owner, it may prove wise to have a contingency plan to cover business emergencies as well.

What should you not spend on?

At times it may be tempting to spend the money you have set aside for an emergency on slightly more frivolous needs such as a holiday or unplanned purchases. However, remember that the fund isn't liquid money and you should utilise these funds only when absolutely necessary.

Saving and earmarking funds for a rainy day is an important financial habit to inculcate. Not only does it protect you and your family in case of an unfortunate event, but it will prevent you from cashing in your long-term investments when the need arises.

The writer is the founder of Happyness Factory