What Is a Reserve Fund?

In life, you may find yourself facing an unforeseen major expense that can potentially drain your finances. If your goal is to create wealth over the long term, it is important to ensure that such unexpected emergencies don’t negatively impact your financial situation. 

But then, how do you do that? Here’s where the concept of reserve funds comes into the picture. With the help of such a fund, you can shield yourself from financially draining emergency situations. Continue reading to get to know the meaning of a reserve fund and how it works. 

What Is a Reserve Fund?

A reserve fund is a designated pool of money, often set aside in a separate account, for covering expected and unanticipated expenses you may face in the future. It is designed to act as a financial cushion that helps you meet unforeseen expenses without denting your finances. 

When you have a dedicated reserve fund in place, you can simply use the money in the fund to meet your emergency expenses without having to use your savings, liquidate your investments or incur excessive debt. 

What Are the Objectives of a Reserve Fund?

Now that you’re aware of the meaning of a reserve fund, let’s look at some of its primary objectives. 

• Financial Stability 

A reserve fund helps bring about financial stability by ensuring you have enough funds set aside to cover contingencies. Additionally, it also prevents the disruption of your wealth creation process since you don’t have to use your savings or investments. 

• Emergency Planning 

A major part of being prepared for an emergency includes having the necessary funds required to tackle the situation. With a reserve fund, you can plan for all kinds of emergencies and contingent events better seeing as you don’t have to worry about funds. Instead, you can focus on what’s more important – setting up an action plan to tackle emergencies in the most effective and efficient manner. 

• Reduction of Financial Risks 

You may face a plethora of different financial risks such as market fluctuations, economic downturns or even unexpected job losses during the course of your life. A reserve fund can provide the financial safety net necessary to mitigate these financial risks to a certain extent. Let’s take the case of a sudden job loss. You could use your reserve fund to meet your expenses for a few months until you find a new job and get back on track.

• Proper Maintenance of Assets 

Over the course of your life, you will probably accumulate a few assets like a motor vehicle or a house. Maintaining these assets through periodic repair and enhancements is key to ensure they last long. Here’s where a reserve fund can help. You can use the corpus in the fund to take care of periodic asset maintenance and repair costs without depleting your savings or investments.

• Prevents Debt 

Debt can be rewarding when used right; taking on debt to create an asset is a good example of this. Availing debt to meet emergency expenses, meanwhile, can negatively impact your financial situation by increasing your monthly outlay. Fortunately, you can avoid all of that by simply setting up a reserve fund. 

How Does a Reserve Fund Work?

Knowing how a reserve fund works can help you understand the importance of the fund better. Let’s look at how the fund works using a hypothetical example.

Assume you’re a salaried employee earning ₹50,000 per month. Your total monthly expenses amount to ₹30,000. You invest ₹5,000 in an index mutual fund and transfer ₹10,000 to your savings account each month, leaving behind ₹5,000. 

You decide to put the ₹5,000 left behind each month to good use by creating a reserve fund. Over the next 12 months, you continue to deposit ₹5,000 in a separate bank account created especially for the reserve fund. 

Around the 13th month of creating the reserve fund, let’s say your vehicle breaks down, requiring you to spend ₹20,000 for repairs. Now, since you have a reserve fund with a corpus of ₹60,000 (Rs. 5,000 x 12 months), you can simply use a portion of it to take care of the repairs. 

Thanks to the reserve fund, you were able to meet the unforeseen expenses without having to dip into your savings, liquidate your index mutual fund or avail a loan. Although you depleted your fund by ₹20,000, leaving behind just ₹40,000, you can quickly replenish it with consistent monthly contributions.

Things To Keep in Mind When Setting Up a Reserve Fund 

Before you proceed to set up a reserve fund for yourself, you need to consider a few factors. Here’s a quick overview of some of the key things you should account for. 

1. Conduct a Detailed Assessment

Conducting a detailed assessment to determine the amount you need to set aside for your reserve fund is crucial to ensure that the fund is adequate. When assessing, remember to consider factors like the costs associated with maintaining your assets, your health and monthly expenses, among others. 

2. Designate a Separate Account 

Having your reserve funds in the same account you use for paying for your expenses can make managing the fund extremely challenging. To overcome this, financial experts suggest creating a new dedicated account for your reserve fund. 

3. Make Regular Contributions 

The best way to build a reserve fund is by making contributions regularly. Depending on your financial situation and income, you can contribute on a monthly or quarterly basis. Such consistent and regular contributions can not only get you closer to your goals but also build financial discipline. 

4. Ensure Liquidity

Liquidity is of utmost importance when setting up a reserve fund. You need to be able to access funds quickly as and when you need them. Therefore, if you plan to invest a portion of your reserve funds, make sure you choose a highly liquid investment option that can be liquidated quickly.

5. Only Use the Fund for Emergencies

It is essential to remember that the reserve fund is only for covering emergency and unexpected expenses. You need to resist the urge to use the money that you’ve saved up to fund your purchases. 

6. Review Periodically 

Reviewing the fund at periodic intervals can help you identify potential gaps and give you enough time to make adjustments. 

Conclusion

Setting up a reserve fund is a crucial step for achieving financial independence. That said, establishing a fund is just one part of the journey. Making routine assessments and adjustments is equally crucial to ensure that you have a corpus adequate enough to handle emergencies and contingencies. 

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