A decent emergency fund helps you see through any rough patches in your life with minimal impact on your financial well being and investment planning.
The pandemic has proven to be an actual black swan moment for everyone. Nobody could predict its arrival, and nobody can say how long it will last. This is how emergencies happen. The least we can do is to better prepare ourselves. In financial terms, you can do that by having a decent emergency fund.
This article explains how to prepare an emergency fund, where to invest the money and some best practices that you can follow so that your money is of help when you need it the most.
What is an emergency fund, and the mistake that most young investors make
In simple words, an emergency fund is a dedicated chunk of money that you set aside from your savings for meeting any emergency. An emergency can be anything that you cannot predict, like a hospitalization, accident, job loss, legal problem, etc.
The biggest mistake that young investors make is that they don’t think through the risks in their financial life. The thought about creating an emergency fund doesn’t cross their mind. As a result, they invest all their savings into illiquid/ long lock-in investment avenues like gold, ELSS, PPF etc. And over time, when an emergency strikes, they are caught unprepared. They end up withdrawing money from their long-term investments and getting into personal loans and credit card debt. This not only derails their long-term investment plan but also saddles them neck-deep in debt.
An emergency fund is like a foundation of your financial building. You shock-proof your finances from the impact of emergencies. As a result, you don’t have to take unnecessary loans and get to continue with your investment plan with a minor pause.
How to calculate the amount of emergency fund
A general rule of thumb is that one should have an emergency fund of up to 6 months of expenses and loan EMI commitments. Let us understand with the help of the following example.
Please note that the amount of contingency fund varies from family to family. For example, suppose you are in a low-risk government job. In that case, even 3 months’ worth of expenses may be sufficient. Conversely, if you work in a private job, you can consider 6 or even 12 months, as there is a greater risk of job loss.
Which is the best avenue to invest the emergency fund money?
Never make the mistake of considering emergency fund money as a return-generating asset. Instead, your primary goal should be that the money should be available in the minimum possible time and in a hassle-free way. In this context, you can consider investing the emergency fund money in the following avenues as below:
# Savings Bank Account: The returns are lower than fixed deposits and mutual funds. However, the ease of availability of money is very high. Moreover, as per existing tax rules, interest on a savings bank account is tax-exempt up to Rs 10,000.
# Fixed Deposit: You can open it easily by visiting the bank branch or through net banking. You can also check out the sweep-in FD facility, wherein money above a certain threshold in your bank account automatically gets converted into a fixed deposit. This money then earns higher interest. Note that interest on a fixed deposit is taxable.
# Liquid Funds: These are a low-risk and tax-efficient way of parking emergency fund money. They are low risk because they invest in highly liquid securities which mature in a very short time, so there is very little credit and duration risk. They are tax-efficient because the income from these funds gets taxed only on redemption of units and not every year.
An intelligent approach is to have some amount (equivalent to 1-2 months of expenses) in a savings bank account and the rest in fixed deposits/liquid mutual funds to earn slightly better return. Try to have the bank account and investments operate on “either or survivor” mode so that your spouse can operate the account in your absence. You should also try to keep some cash at a safe place in your home. This can help to make any urgent cash payments like initial deposit in hospital, ambulance, etc.
Some other tips relating to the emergency fund
# Focus also on having the right insurance apart from having an emergency fund. Having a contingency fund does not mean that you don’t need to buy insurance policies or vice versa. Both go hand in hand.
# It’s best to pause any existing monthly investments/SIPs in case of an emergency. Several mutual funds offer a pause facility for SIPs.
# NEVER EVER consider credit cards and personal loans as your emergency fund.
# Make sure to inform your spouse on how to access emergency fund money in your absence.
The emergency fund has an important place in the overall personal financial planning. A decent emergency fund helps you see through any rough patches in your life with minimal impact on your financial well being and investment planning. However, one should be careful not to spend that amount on discretionary purposes and ensure that it is easily accessible when needed.
(By Sujit Bangar, Founder, Taxbuddy.com)