Monday, 21 May 2012

Build an emergency fund – What, why and how of emergency fund

What is emergency fund?
Emergency fund is like an insurance policy and once you have it, guard it carefully. It's not a piggy bank; you should not be dipping into it for incidental expenses. Use it only in the event of an emergency, and hope that an emergency never happens. Remember, once that money is spent, the time it takes to replace it is always much longer than anticipated. Start now and save whatever you can, even if it isn't much. Some day, when you need the money, you'll be glad you did.
Emergency fund can be explained as an account that is used to set aside funds to be used in an emergency, such as the loss of a job, an illness or a major expense. The purpose of the fund is to improve financial security by creating a safety net of funds that can be used to meet emergency expenses as well as reduce the need to use high interest debt, such as credit cards, as a last resort.
Why we should have an emergency fund?
1.      How many times does it happen that you feel leaving your current job and pursue your passion or to find a new job about which you are passionate. BUT you can’t afford to do it because you have to meet month end, pay monthly installments, monthly bills and who knows whether finding the job you are passionate about might take 4-6 months.
2.      If you can get a 6 month ahead in your financial requirement, your financial stress will drop way down.
3.      If you are living paycheck-to-paycheck, you will come up with times when you have to pay a bill late, or overdraw your bank account. With an emergency cushion, you avoid these financial hits.
4.      If unexpected things come up, you don’t have to continually re-factor your budget to pay for these things. With an emergency fund, it makes budgeting much easier.
So what is the answer to the above question- it is to build an emergency fund.
How we should go about building an emergency fund.
The first step in the process is to figure out how much you spend each month. Now suppose your monthly expenditure is 30,000 (in currency of your country, I live in India so I have assumed in INR), the recommended cash reserve/ emergency fund should be:
Emergency fund = 30,000 (average monthly expenditure) X 6 (months) = 180,000
While your household expenses may be higher or lower than the average, there's no doubt that even six months' worth of expenses is a big number. One look at that number and the average person's first reaction is, "I can't come up with that kind of money as emergency fund."
Now that you have things in perspective, it's time to start saving. Approach this effort the same way you would approach any other financial goal. Put together a plan and execute it. Reaching that number (Rs.180,000 in our illustration) will be your initial goal. To achieve your six-month target, you need to start saving money.  If we consider your initial goal, the table below illustrates how much you will need to save each month, over a five-year or a 2.5-year period.

5-Year Plan
Amount Needed per Month*
2.5-Year Plan
Amount Needed per Month*
60 months
30 months

*For the sake of simplicity, I have not factored in the interest that you will earn on your savings.
Another, better option is to a mutual fund company and ask them the amount of monthly contribution you require to put in the mutual fund so as to reach your required amount of emergency fund in your targeted period.
Second and most important step
To save the money, you have to curb your expenses. May be you might be fine with single telephone connection in your house, single cable connection, shopping for what you need rather than what you want more often than not.
Ideally, you should treat your emergency fund like any other recurring bill, that you must pay each month. Dedicate the appropriate amount from your paycheck and set it aside. While most people have no qualms about sending enormous amounts of money to credit card companies, on a regular and systematic basis, they balk at the idea of paying themselves, first.
Create your emergency fund and feel safe, relaxed and take financially independent decisions.

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Always remember, Life is Good!!!!!
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