2020 was an unforgettable year, and it taught us many valuable lessons. From spending time with our families to rediscovering our hobbies, we all learned something new. Financial literacy also improved dramatically, as people understood better how to plan their finances. Many started setting up emergency funds to ensure they were prepared to deal with any financial challenge in the future.

But what is an emergency fund, and is it really the only solution to emergencies? Let’s find out!

An emergency fund is an essential corpus that you must keep aside to tackle emergencies. It is a fund that you can fall back on at the hour of crisis or for unexpected and unplanned scenarios, and not for meeting your routine expenses. So, you must design it specifically to meet unanticipated financial shortfalls that may apply to you.

Individuals should keep their emergency funds in accounts that are easily accessible and easily liquidated.

The best size for an emergency fund depends on a number of factors, including your financial situation, expenses, lifestyle, and debts. Many financial advisors recommend saving enough to cover anywhere from three to six months’ worth of expenses, which can help you whether a modest healthcare bill or a short bout of unemployment.

How to build an emergency fund?

An emergency fund is not built overnight but is rather done gradually.

Here are the steps you can follow to build an emergency fund:

Calculate your monthly expenses. Pre-decide your monthly expenses. Try to control your expenses as much as you can so that you save enough to invest in an emergency fund.

Calculate the total corpus you wish to save: Determine the required corpus to figure out how to add up to your living expenses of at least six months.

Set a monthly savings goal: This will get you into the habit of saving regularly and ensure that the task of creating an emergency fund feels less daunting. One way of doing this is starting a SIP (systematic investment plan). Assess and adjust contributions. Make sure to check after a few months and evaluate how much you are saving and adjust if you need to add more funds.

Short-term emergency funds

This is the fund you rush to in cases of emergencies. Such a fund should offer little in terms of interest but allow immediate accessibility, which in case of extreme situations can suffice till you gain access to your long-term emergency funds.

What’s a better investment option?

A Liquid mutual fund though is a better option thanks to the easy liquidity and much less volatility of such instruments. Take into account the capital gains tax considerations if you choose to follow the debt mutual fund route.

Considering the fact that you can withdraw quickly from debt funds, these can provide a good option to park your emergency fund. These also generally give better returns than savings bank account's interest

Where to park your money?

When the time comes to start building your emergency fund, where is the best place to keep it? It’s best to keep your emergency fund separate from your other bank accounts. You want your emergency fund to be accessible in case you need to access it quickly.

Here are some of the best options for where to build your emergency fund.

1. High-Yield Savings Account

Opening a high-yield savings account to start an emergency fund makes a lot of sense. Almost all high-yield accounts are found at online banks. You’ll need the use of another bank account for transferring money in and out of your high-yield savings account.

2. Money Market Account

Money market accounts are similar to high-yield savings accounts. While both earn a higher APY than traditional bank accounts, they are different in other ways.

3. Certificate of Deposit

Certificates of Deposit (CDs) are another possibility for your emergency fund. They are different from other options on this list because they require you to keep your money in the account for a specific period of time in exchange for receiving a guaranteed rate of return. This could be as short as a month or as long as five or more years.

4. Traditional Bank Account

If the idea of keeping your money in an online account or tied up for an extended time doesn’t sound ideal, you can always keep your emergency fund in a traditional checking or savings account.

5. Individual Retirement Account

There is a case to be made for putting money into an investment account instead of keeping a more conventional emergency fund.

6. Liquid mutual fund

A liquid fund is a category of mutual fund scheme that invest in debt and money market securities with a maturity of up to 91 days only

Considering the fact that you can withdraw quickly from liquid funds, these also generally give better returns than savings bank accounts interest.

Conclusion

An emergency fund is a financial safety net for future mishaps and/or unexpected expenses.

Emergency funds should typically have three to six months’ worth of expenses, although the 2020 economic crisis and lockdown has led some experts to suggest up to one year’s worth.

Individuals should keep their emergency funds in accounts that are easily accessible and easily liquidated.

It may be tempting to use your fund for incidental or frivolous purposes, so make sure that you don’t deplete this resource for any purpose other than an actual emergency.