Creating an emergency fund has been accepted as one of the primary goal to save for, irrespective of your age and stage in life. Such a fund provides the cushion a household needs to protect itself from loss or reduction in income or an unplanned large expense that can derail its financial security. But building the emergency fund in itself is not an end. The fund has to be continuously maintained and managed. There are three aspects to managing an emergency fund: determine the conditions under which the fund will be used, hold the fund in a way that it is accessible when these situations arise, and restock the fund every time you have had to draw on it.
Imagine that your emergency fund is sitting with your other savings when you need money for daily expenses, that vacation you so wanted, or the investment opportunity that you don’t want to miss. In such situations, your discipline and will power may not be enough to keep your emergency fund safe. A more workable plan would be to cacoon this money from your other needs and desires. If you hold your emergency fund in the same bank account or investments where you hold your money for other expenses, you may start seeing it as available money. Instead, hold this fund in a separate bank account and investments.
Ideally, a situation should tick three boxes for you to justify dipping into this fund:
—it should be unexpected,
—it should be a need and not a want or desire,
—it should be unplanned, urgent and something that cannot be postponed.
These would be situations like losing your job, a medical emergency, travel to take care of urgent family matters.
Have a framework that helps you determine which expenses warrant the use of your emergency fund. This will keep the fund safe for situations that have the potential to upset your financial life.
Use the emergency fund only when the situation merits drawing from it. Your funds held in a savings bank account can be easily withdrawn, while those in short-term mutual funds and short-term deposits with banks can typically be accessed in a day or two. You can use the free credit period on credit cards to tide over the delay in redeeming your emergency investments, which may take a bit more time to realize. Make sure you pay off the credit card debt as soon as the investment funds come through, so that there is no interest cost. Once used, you have to replenish it so that you are ready to meet the next emergency. The steps are similar to creating a fund for the first time.
Reassess the fund requirement before you set your saving targets. A change in your situation may increase, or even decrease, how much you need to keep in an emergency fund. For example, if your household has gone from a double income to single income, then you may have to consider increasing your emergency fund, and vice versa. Or, when your income and savings ratio have stabilized and show a rising trend, then you may be justified in reducing the amount held for emergencies. Set a time frame within which you have to build it back and do it on an emergency footing.
You may need a special budget to find the savings to restock your emergency fund. Call this the temporary emergency budget because it is going to be a tight one, which has to allow you to replenish the fund as quickly as possible. Trim expenses to bare essentials for this period. Challenge all the fixed expenses and see where you can find savings. The allocation you may have made for recreational and personal needs, may have to be sacrificed to find the savings. Apart from curtailing expenses, you should also look for ways to expand the income to increase savings. A second job or income in the household will go a long way to quickly rebuild the fund. Once your task of replenishing is over, you can slowly reintroduce the spending that you had cut out and eliminate the second income if earning it is burdensome.
Any bonus, refunds, or other money received should be used to top-up the emergency reserve. Funds received on redemption or maturity of investments may also be used, though diverting these funds may mean that the goal for which that investment was originally earmarked will be delayed or under-funded unless you catch up on the savings goal.
Refilling the emergency fund takes precedence over most of the other goals that you may be saving for, except perhaps the retirement goal. The periodic savings that are being made should be first assigned to the emergency fund till it is stocked-up. If you have money saved for goals that can be postponed, say a holiday or the down payment of a second home, the funds for it could be diverted to the emergency fund.
One way to replenishing the emergency fund faster would be to assume that the money will be used up, and overfill it with your savings. Given that liquidity, and not return, is the priority for investment avenues in which emergency funds are held, holding more than required in such investments will be under-utilizing your money. One way to pad your emergency fund without compromising on returns is to hold the extra savings in investments with a medium-term horizon, which earn better returns. These investments should not be considered part of the emergency fund and should not be assigned to any other goals either. They should be held to replenish the emergency fund when required. It may take some time to redeem these investments but you know that they are there and you can adjust your emergency saving targets accordingly.
To begin with, the financial steps you have to take to rebuild the fund may seem hard. But they would give you the comfort of having a cushion in an emergency; and this will be the motivation to stay the tough course to create the buffer again.