Avoid crisis on a rainy day: What is an emergency fund and how much you should save, explained

A “rainy day” fund or emergency fund is crucial aspect when planning your fiscal goals alongside the asset allocations, investments and retirement fund. Simply put, it is money set aside for sudden and unexpected situations, for example car repair, urgent house expenses, a medical bill or job loss.

The existence of your emergency fund can help tide over sudden needs without a loan, credit card or borrowing from friends. More than money, it gives you freedom to handle a crisis without putting immediate stress on your day-to-day finances.

How much emergency fund should I have?

The aim of an emergency fund is to cover unexpected expenses that could hit your daily needs or financial goals i.e. breaking your fixed deposits, pausing SIPs, or liquidating investments before tenure, etc. It also allows you room to deal with situations without immediately acquiring debt, unless absolutely necessary.

“Most people aim to keep 3 to 6 months of essential expenses set aside,” according to Clear Tax. It further noted that if you are a freelancer, have medical conditions or dependents, or are someone with unstable income flow, this fund should increase to cover 6-12 months of expenses.

To calculate your emergency fund:

• List all your non-negotiable monthly expenses, including EMI, electricity, food and groceries expenses, home loan, internet bill, insurance premiums, loan repayments, school fees, transportation expenses, and water bill.
• This total should be multiplied by 3-6 in increments, as you reach your goal.
• Further, if you are on unstable income, the expenses total should be multipled by 6-12, as you reach each goal.

It is advisable to take stock of your expenses every few months to keep a track of how much you are spending and if the fund total meets calculations.

How to build an emergency fund?

“Build the fund slowly yet consistently and start with whatever amount you can and adjust yearly. Keep the fund in safe, liquid options like savings accounts, sweep-in FDs, or liquid/overnight funds,” the Clear Tax report added.

For example, if your monthly spend is ₹25,000 for six months that works out to ₹1.5 lakh as emergency fund. This can be built in stages, starting from ₹500-1,000 each month, or even a little more or less depending on your ability. However, the key is to consistent and habitual.

In a post on social media, CA and financial advisor Nitin Kaushik advised a two-phase build-up.

• In phase one: Save one month of expenses ( ₹25,000) by cutting every non-essential for 60 days. He termed this as the “mini fund”.
• For phase two: He suggests automating deductions into a recurring deposit (RD) or a liquid fund systematic investment plan (SIP). “Treat this like an EMI you owe to your future self,” he added.
• Kaushik also suggested using “every bonus, tax refund, or side-hustle check” to pad your savings until you hit your six-month target.

Where should I invest my emergency fund?

Your emergency fund should be separated from the accounts you use for daily expenses. There should be a minor barrier so that it's not too easy to reach for daily use; but liquid enough to access when required.

You should also stay away from investing your emergency funds in volatile assets such as penny stocks, volatile equities, which can fluctuate significantly in the short term.

Below are some options:

Disclaimer: This story is for educational purposes only. The views and recommendations made above are those of individual analysts or broking companies or user-generated content from social media, and not of Mint. We advise investors to check with certified experts before making any investment decisions.