Create Your Peace of Mind with Freedom and Security by creating an emergency fund.
Creating an emergency fund for financial security is vital. You never know what will happen in the near future. The level of unpredictability is very high, especially post-COVID. One virus attack and everything has changed forever. Whether it’s working style, mode of interaction, economic conditions, or career opportunities, everything has changed. Life and life events are so uncertain and insecure, and your financial situation is as well. So here’s a question: have you created your emergency fund? Or would you prefer to borrow debt at higher interest rates in case of an emergency?
Any sagacious person chooses to build their emergency fund instead of borrowing from the market.
What is an emergency fund?
In personal finance, an emergency fund refers to a fund created by an individual or household to protect themselves financially in case of any emergency.
This emergency or financial distress could be job loss, unforeseen medical expenses, a drop in income, or any accident or natural disaster. Please don’t confuse an emergency fund with savings because these are two different things. Let’s see how.
Emergency Fund vs. Savings and Budgeting
Savings are when you set aside a portion of your regular income to meet your future financial goals. These goals could include short-term financial goals as well as long-term financial goals. In short-term financial goals, you might include saving for a down payment on a house or vehicle, while in long-term financial goals, you could save for your retirement or your child’s post-secondary education. An emergency fund includes saving for unexpected, sudden changes in your financial requirements. These changes could be a sudden job loss a drastic change in your income, or relocating to a new city.
Now, there could be another question: Is it necessary to save for an emergency? Let’s see.
Why Create an Emergency Fund?
The answer is very simple: to cover yourself financially for any abrupt financial crisis, such as:
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- A drop in income or irregular income: If you don’t have a high salaried income stream or you own a small or medium-sized business or work as a freelancer in any field, you must create an emergency fund because you may face periods of financial windfall as well as financial hardship. For example, if you’re a freelancer like me, you could have a lot of work and money one month and no work or income the next. In such scenarios, if you don’t save money for an unforeseen financial crisis, you’ll likely have to borrow money from the market at a higher interest rate, burdening yourself with debt.
- To face unforeseen layoffs: There were massive layoffs due to COVID-19 in almost every sector, leaving millions of people worldwide facing sudden job loss and a very challenging financial situation. Creating an emergency fund is vital to face such situations.
- Shift in taxation policies: Changes in taxation policies can adversely impact the financial health of both wealthy and middle-class individuals. To escape the burden of taxation, building your emergency fund is crucial.
- To meet a medical emergency: In the case of a medical emergency, if you don’t have an emergency fund, you could face a difficult situation. You might have to borrow money from relatives or the market at higher interest rates, as insurance companies generally don’t cover the full cost of medical expenses.
- To survive family discord: Sometimes, family problems or property-related issues can arise. In such conditions, having financial safety is essential to survive.
- To survive in case your digital identity is stolen: In the digital age, people earn and learn online with their digital identity, and the rate of cybercrime is high. If your digital identity is stolen or one of your main sources of income stops yielding money, having an emergency fund can help you survive.
- For mental relief: When you know you have enough funds to meet any unforeseen event, it gives you confidence and peace of mind. That’s the magic of creating an emergency fund.
Now, what could be the next question? Let’s see.
What Should Be the Size of an Emergency Fund?
The size of an emergency fund depends on several factors, such as:
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- Standard of living
- Lifestyle
- Nature of expenses
- Size of debt
To determine the size of the fund, create a budget. Before COVID-19, financial experts used to suggest that it should cover six months’ worth of expenses. However, post-COVID, they suggest it should cover six months to one year’s monthly expenses. For example, if your monthly income is $50,000, the size of the emergency fund should be between $300,000 to $600,000.
How to Build an Emergency Safety Net?
People often think that budgeting and saving require a huge amount of money and time to build an emergency fund. But remember, “Rome wasn’t built in a day.” You just have to take the first tiny step. Here are some tips to consider:
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- Calculate the required amount of money.
- Create a special high-yielding savings account.
- Since an emergency fund is different from saving, don’t cut money from savings. Differentiate between wants and needs, then save money from wants and deposit it into an emergency fund.
- Explore new avenues for extra income.
- Start and earn from a side hustle.
- Create an emergency fund first before investing your money if you’re unsure about what to do first.
- Transfer tax refunds to an emergency fund.
- You can build it over time, but start now.
- Stay consistent.
- Choose automatic money transfer from your main account to an emergency fund (a special savings account for emergencies).
- Deposit all unexpected income into an emergency fund until you achieve your set goal.
- Prioritize and maintain consistency when creating an emergency account.
After creating a separate fund for unforeseen events, should it be kept in a liquid savings account or should you invest it somewhere?
How to Keep and Where to Invest Emergency Funds?
According to some financial gurus, regardless of the size of the emergency fund you accumulate, it’s important not to keep it all in cash (liquid form) or just deposit it in a regular savings account. So what should you do? Good question. Decide on a ratio of 20:30:50, or 20:20:60. If you choose 20:30:50, keep 20% in cash, 30% in a high-yielding savings account, and invest the remaining 50% in a liquid mutual fund.
Things to consider while investing in emergency funds:
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- Categorize it into two parts: long-term and short-term emergency funds.
- Invest the long-term fund in a debt mutual fund (a debt instrument with a maturity of fewer than 91 days).
- Since it’s an emergency fund, always consider redemption policies.
- Invest in such a way that you can liquidate it immediately, within less than two days.
How to create an emergency fund if you are a college student or have a low income?
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- Cut unnecessary expenses and adopt frugal living.
- If you’re a student, provide tuition and earn extra income.
- Learn digital skills like graphic design or accounting and offer part-time services to earn money.
- Live a simple life without unnecessary luxury expenses.
These small considerations can be very beneficial in times of emergency, helping you avoid bad loans and reduce stress about the future.
Conclusion
Unlike many other things in life, especially in the realm of finances, you need to go through a process to achieve financial freedom. Creating an emergency fund is one of the cornerstones of achieving that goal. This is especially crucial in low per capita income countries like India, where unemployment, disguised unemployment, and job uncertainty are major problems. An emergency fund can help you navigate your life more effortlessly.
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