Why should you build an Emergency Fund

7 MinsNovember 15, 2019

Life throws unpleasant surprises when you least expect it. Unforeseen situations such as a medical emergency, critical illness of a family member, sudden demise of the breadwinner, loss of job, unexpected rise in your child’s school fees, natural calamities, home repairs, etc, can catch you off-guard and disrupt your plans.

emergency fund

Let’s talk about a few important ones:

Layoffs – There is no such thing like a job for life these days. Don’t forget that economic slowdowns, which potentially causes job losses, are part of economic cycles. Moreover, besides macroeconomic issues, there could be micro or strategic issues at the company level, which too could make you vulnerable to job loss. This could affect your flow of funds causing hardships to you and your dependent family members.

Medical emergency – Healthcare costs, as you know, are rising. God forbid if a medical emergency arises and you do not have an adequate health insurance cover; it could drain out your financial resources that, perhaps, may have been apportioned for other vital financial goals, such as your child’s future needs (education and wedding expenses) and your own retirement.

Sudden rise in school fees – Schools today increase fees on a regular basis. As a parent, while you desire the best for your child, it is imperative that you also account this additional expenditure in your emergency fund.

Unexpected repair expenses – Picture this. On a pleasant sunny morning, you decide to take your family for a drive, but your car breaks down. Or during monsoon the roof of your house begins to leak and you have to get it repaired. Similarly, natural calamities (earthquake, storms, hurricanes, tsunami, floods, etc.) could damage property and dent your finances.

An unexpected loss – Such a loss can put the family under tremendous mental anxiety. But having the requisite financial support can help to a great extent. Therefore, it is important to prepare yourself financially so that you can overcome life’s testing events. Hence, one should not ignore the need for creating an emergency fund.

Saving for a rainy day or building an emergency fund (also known as a contingency fund) is crucial for your financial wellbeing. It is, in fact, one of the key elements in the art of money management.

[Also Read: Which Savings Account is Right for You?]

Here’s how setting aside an emergency fund helps…

1) Lowers your stress levels – Having an emergency fund gives us the confidence to handle testing times financially and provides courage to confront and resolve the situation. For instance, assuming you quit your job. Knowing that there is some money that can sustain you for a few months will ensure that you don’t say yes to the first job offer you get, even if it does not meet your qualifications or requirements.

2) Can help keep debt under control – If you hold an adequate amount as an emergency fund, borrowing from friends and relatives can be avoided. Plus, you can repay your credit card dues, even as you use your card for basic necessities or medical expenses. In another situation, say you took a personal loan in the past and still have a certain amount outstanding. If you lose your job, the emergency fund could be used to repay the personal loan in part or full.  This is better for your credit score than no repayment at all.

3) Can curb frivolous spending – When you park your emergency fund separately in an earmarked Savings Account or a liquid fund/overnight fund, instead of utilising it on certain avoidable lifestyle expenses, it indirectly helps to control superfluous spending. This inculcates good financial discipline and lowers your outgo; rather than spending way too much on things you do not need.

4) Safeguards the financial well-being of your loved ones – Holding an adequate amount in an emergency fund safeguards you and your family members, who can get emotionally and financially run down while dealing with a crisis. For instance, an unexpected medical emergency can be emotionally draining for the family members of the patient. In such a situation knowing that there is sufficient money in your Savings Account to tide over immediate needs, will keep money worries at bay, for some time.

What should be the size of the emergency corpus?
To determine the optimal size of the emergency corpus or a contingency fund, you need to account for various daily household expenses, including EMIs, and other unavoidable expenses (the responsibilities you shoulder) that must be absolutely met no matter what the situation is.

Broadly, 3 to 6 months of regular expenses (here you can change the number of months depending on what the calculator will say), including EMIs and other unavoidable expenses, should be maintained as an emergency fund (also known as a contingency fund).

In addition, you should not miss paying your life and health insurance premiums. In case, you do not have a health insurance policy (an absolute necessity in today’s times), you need to have bigger corpus for your emergency fund to cope with medical expenses, should such a situation arise.

Your emergency or contingency fund must be parked in safe and liquid avenues. The purpose of a rainy day fund is not to earn high returns, but to have instant access to funds during an emergency. Hence a Savings Account or a short-term Fixed Deposit are good options to save for your emergency fund.

Remember, if you under-allocate funds, your contingency planning exercise will be ineffective, and you may drain your finances while the testing situation continues.

Contingency planning is based on the premise: Hope for the best and be prepared for the worst. So, prepare well by building an optimum emergency/contingency fund, and make sure you are adequately insured as well. Having a safety net is necessary for you and your family.

So, do not delay in setting aside money towards an emergency fund. Get started today!

Disclaimer: This article has been authored by PersonalFN, a Mumbai based Financial Planning and Mutual Fund research firm. Axis Bank doesn't influence any views of the author in any way. Axis Bank & PersonalFN shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.