All you wanted to know about Emergency Funds
The word emergency might make you press the panic button. But, emergency fund does exactly the opposite, it eases your financial struggle at that crucial time. The article below will put some light and try answering what, why, where and how questions around emergency fund.
The year 2020 has been quite a roller coaster for all of us. With our lives being dominated mainly by external uncontrollable factors, it has been a tough ride for most of us. In these times of corona virus pandemic, personal health has remained top priority. However, not far behind comes our financial health concerns. Only if the financial aspect would have been tackled in a more matured manner, the ride would have been smoother for many. This is where emergency fund comes into picture.
What is an emergency fund?
Emergency fund or contingency fund, in simple terms, is your financial safety net during unexpected times. It can also be called as ‘to your rescue’ fund. It will help you serve your financial needs during tough and unexpected situations life throws at you. Thus, it is an important aspect of being financially secure.
Why have an emergency fund?
Life is uncertain and incase if such uncertainty arises, your basic needs and standard of living might take a hit. The emergency fund can help you take care of your medical needs, day to day household expenses and other unavoidable expenses in case of loss of job, pay cut, any social unrest or the pandemic that wee are currently facing etc. In absence of these funds, people tend to take loans; especially for medical needs; which are mostly avoidable. Also, personal loans are usually an expensive option. It is important to understand that these funds should be used only at the time of genuine emergency. It should not be used for any planned expenses buying a new house or a new car. Also, cash required to spend at sale in Zara unfortunately doesn’t count as an emergency.
How much should be the corpus for emergency fund?
The amount of emergency fund you require depends on various factors like your monthly expenses, number of dependents in the family, debt (if any). It has to be noted that emergency funds determination should include only essential expenses and nothing leisure. Most of the Financial Planners recommend that an emergency fund should at least be 6- 12 months of essential monthly expenses. However, it will vary if the number of dependents is more or the debt component is high. For example, if essential monthly expenses of a household are Rs. 40,000 then, at least Rs. 2,40,000 should be saved as emergency fund, considering there is no major debt. Once you have determined how much emergency fund is needed, the next step is to save this amount. The best way to start saving is to reserve small monthly amounts from your daily expenses. Also, cutting down on additional avoidable expenses. Do not try and save the corpus too quickly as it will impact your regular cashflow. It is more feasible to maintain a separate account for emergency fund so that it is not used for any other need.
Where to invest?
Since emergency fund would be used in times of personal financial crisis, it is important that the saving or investment instrument selected should possess these below features:
- Highly liquid: Liquidity mean how quickly your investments can be converted into cash. So, more liquid the instrument, more beneficial it is during the crisis.
- Easily accessible: Financial crisis usually strike fast so it is very important that the fund allocated are easily accessible to convert it into cash.
- Safe from market fluctuations: These funds are usually not for growth purpose. Their main aim is to help you during tough times. Therefore, they should be away from high risk investments. Investing in equity market or equity related mutual fund is not a good idea.
Depending on the above factors the following investment options would suit the best for these funds:
- Bank Savings Account: The easiest way to park these funds would be in a bank’s savings account. Explore options as to which savings bank account provide high interest rate.
- Bank Fixed Deposits: Since these instruments are highly secure, many people do opt for these. Make sure they are flexible in nature so that in case of emergency it can be readily converted into cash.
- Liquid Mutual Funds: You can consider investing a part of the fund in instruments like liquid mutual funds. They give better return on investment compared to the interest earned on savings account, and at the same time are highly liquid. They are also safe, as liquid funds are away from equity market fluctuations as they invest in high rated Government bonds and other high rated debt instruments.
The figure below shows simple steps to create emergency fund.
Review your emergency fund
As important it is to review investment portfolio from time to time, it is equally important to periodically review your emergency fund corpus too. You will need to review the fund corpus when:
- There is increase in income or receipt of bonus or other cash incentives
- Your monthly household expenses have increased
- You have taken additional loan
In all of the above cases or any other, make sure that your fund amount also grows.
The key reason for having a financial plan is to prepare for future; and emergency fund is an essential component of any good financial plan. It will prepare you for unexpected setbacks and reduce your dependence on borrowing money, most likely at high interest rates. Thus, having a fallback plan is always a great idea; and emergency fund is that fallback plan of yours which can help you sail your boat smoothly.