Your First Step to Financial Freedom: Set Up an Emergency Fund

In 2013, I was diagnosed with Tuberculosis.

I had to take a break from work for 6 months and pay for expensive medical treatment. My health insurance did not cover it. How did I manage?

Short answer: Emergency fund.

What’s an emergency fund and why is it important?

Emergency fund is the money you set aside for meeting unexpected emergencies. It’s important for several reasons.

• Peace of mind. You don’t have to ask for financial help from your relatives or parents when you face an emergency
• Gives you enough time to learn a new skill and get a better job in case you lose your current job
• If you don’t like your current job or get bored with it, take some time out to reflect on what you really want to do

The different types of emergency funds

• Money you have in your bank account which you can withdraw quickly
• Your credit card which lets you pay the bills now and settle the payment later
• Cashless hospitalization health insurance which covers the cost of your treatment

How much money should I have in my emergency fund?

The general rule of thumb is 6 times your monthly expenses. Consider EMIs and other recurring payments like quarterly school fees for kids, insurance premiums etc.

It’s not recommended to keep more than 12 months of your expenses in an emergency fund.

How can I save up to reach my emergency fund target?

Let’s admit it;

Most of us won’t have enough money to set aside today to meet our emergency fund targets.

That’s OK. It’s never too late.

Here’s a plan to save up each month and reach your target quickly.

Step #1: Take a comprehensive health insurance policy (Tax Benefit)

Even if your employer provides you with an insurance policy, take an extra cover.

My health insurance coverage amount is 25 lakhs and I pay a premium of Rs 15,000 a year. Considering healthcare costs in India, aim for a coverage value of at least Rs 10 lakhs.

Step #2: Maximize your credit card limits

Make sure that your credit card spending limit is maximised. As long as you spend responsibly, there is no issue with a large credit limit.

A larger credit limit gives you more flexibility to manage your sudden expenses. Most cards will let you convert large spends into EMIs. This will come in handy when you are facing temporary cash crunch.

Step #3: Create a plan to reach your target goal

Once you have a target amount in mind, break it down to understand how much money you need to invest every month.

Answer these questions:

1. Is there a bulk amount you can invest today? If yes, set it aside
2. What is the maximum amount you can save every month? This will give you an idea how long it will take you to reach your goal. The sooner you can reach your goal, the better
3. Can I let go of some of the unwanted expenses/luxuries I enjoy currently?

Now that you have an idea about how much you need to invest every month, let’s set the plan in motion.

Plan #A: For people who want least risk

Step #1: Use a separate savings bank account. Do not mix money required for your regular expenses with emergency fund

Step #2: Apply for a debit card and activate internet banking for the new bank account

Step #3: Set up an automated transfer to your new savings bank account

Plan #B: For people who are willing to take moderate levels of risk

Step #1: Choose a liquid / ultra-short term mutual fund. Head over to value research to select a mutual fund which will suit your requirements

Step #2: Open an account directly with the mutual fund company or through a distributor. You don’t need a DEMAT account for mutual fund investments. The process is pretty simple

Step #3: Once your account is active, set up a monthly investment (SIP) for the duration you need to invest for

Step #4: Every year, as your salary increases, increase your SIP amount by at least 10%.

You can choose to go with any investment option as long as it fits into the following criteria:

• Low risk – You are not playing the long-term game. Choose an investments options which has relatively low risk
• High Liquidity – You should be able to access your money quickly. Money which takes more than a day to come to your account is not a good idea

Note: Physical cash is not an ideal form of emergency fund. Keep only a small percentage (less than 10%) of your emergency fund as physical cash.

What qualifies as an emergency?

I don’t like to be preachy. I am not going to tell you what is and what is not an emergency for you. You are smart enough to decide on your own.

I follow a simple rule to classify something as an emergency. If I do not do this now, will my life or the lives of the people I love and care for get affected? If there is a negative impact, I will consider using my emergency fund.

Final Thoughts

It’s important that you have an emergency fund in place to enjoy financial independence. Start small. Start today. Even rupee you set aside counts.