DIY Financial Plan step 3:
Emergency Fund: 6 Months’ Salary Or 6 Months Expenditure?

Reading Time: 2min 22sec

18-Feb-2024

Introduction

In our previous blogs, we understood what budgeting is, and explored the the 30-30-30-10 rule as a better alternative to the 50-30-20 rule. We also emphasized the importance of tracking monthly expenses. In case you missed our previous blogs, you can find them here Blog 1: Why 50-30-20 rule is not enough? And Blog 2: How to set your budgeting with 30-30-30-10 rule?

Now that we understand all this, let’s move forward to Do-It-Yourself Financial Plan Step 3, which involves building our EMERGENCY FUND.

What is EMERGENCY FUND?

As it goes by the name, this fund is for unexpected situations. For example,

COVID 19 led to job losses for many, cutting off their primary or sole source of income. This is a prime example of an ‘emergency’.
If you are in a business, you may face an unexpected downturn in sales. This is an ‘emergency’ condition.
In case some unforeseen expenses occur like flying back to your hometown on an immediate basis or buying a phone as the current one stopped working, also qualifies as an ‘emergency’.

Let's understand this with an example

Aditya is a 28-year-old guy working professional, who faced a pink slip from his company during Covid.

His sole source of income, which was Rs.45,000/- per month, just vanished in a day.

Let’s understand how one can be prepared for such unfortunate times.

Determining the right amount

Analyze your unavoidable or essential expenses from the 30-30-30-10 rule of budgeting.

Is paying your rent or any utility bill (LIVING expenses) avoidable? No.
Is it wise to postpone your EMIs for some months? Or informing your dependent parents about financial difficulties? (LIABILITIES). No

What is avoidable in emergencies?

Your contribution towards INVESTMENTS can take a back seat for a while. This expense is avoidable.
Your ENTERTAINMENT expenses can also be trimmed down in case of emergencies. This 10% is avoidable.

This is the reason why it becomes important to track your monthly expenses and distinguish between our MUST expenses v/s our WANTS. Once we get to know our must expenses (which may cap to 60% of our monthly income), we should start aiming to save at least 3 to 6 months of our MUST expenses. This accumulated fund will provide us a cushion and act as a safety net during emergencies, providing financial stability during uncertain times.

If you think your job is stable, and there are very minimal chances of your company offering you a pink slip, maintaining at least 3 months of monthly expenses should be enough.
If you think your company can lay off people when a crisis occurs, it is better to have at least 6 months of monthly expenses accumulated.
If you think that your income is unstable or the industry that you serve is cyclic, you should plan to have at least 9-12 months of monthly expenses kept aside.

Let’s continue with the same example.

Aditya is spending Rs.20,000/- every month on his living and sending Rs.5,000/- to his younger sister every month for her hostel expenses. Rs.10,000/- is being utilized for his parent’s well-being.

Now, looking into his liabilities and living expenses, he needs to save at least Rs.35,000/- * 6 months i.e. ~Rs.2 lakhs.

This amount can be kept aside in the form of liquid money or Fixed Deposits or Short-term Debt funds, which we will talk about in our upcoming blogs.

Conclusion

Now that you know your monthly expenses and the income stability factor, prioritize accumulating the required amount, and keep it aside before starting your Financial Planning. See you soon in the next blog.

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