scorecardresearchA simple guide on how to go about building your emergency fund

A simple guide on how to go about building your emergency fund

Updated: 17 May 2022, 10:47 AM IST
TL;DR.
It is important to have a definite amount of money specifically kept aside to meet unforeseen events. This money should be sufficient to keep you afloat in case there is a job loss or other such event where the income suddenly stops.
Don't work hard to grow your money, make your money work for you.

Don't work hard to grow your money, make your money work for you.

We've all heard multiple times about building an emergency corpus as a part of ones financial planning. A basic search of google would throw up a lot of content about this topic. However, the term emergency corpus is as personal as it could get. Need for building an emergency corpus arises when there is uncertainty about future cash flows. Simple example would be a person who is employed at a company and is whole & sole bread winner for the family. What would happen if he were to lose his job? What if there was a medical emergency?

We have already witnessed a black swan event in 2020 when covid outbreak struck & most of the businesses were closed for more than 6-8 months. Employees had to face salary cuts as companies were not able to generate enough revenues to afford salaries. This lead to creation of gap between income inflows & expense outflow.

It is important to have a definite amount of money specifically kept aside to meet unforeseen events. This money should be sufficient to keep you afloat in case there is a job loss or other such event where the income suddenly stops.

Let us try to understand everything about emergency corpus & things that should be considered while calculating the amount of emergency funds.

Survival expenses: Our regular expenses can be classified into three categories viz. necessities, discretionary & fixed financial commitments.

1) Necessities: This would include grocery bills, electricity, utilities, fuel cost, medical expenses & children education costs. These costs are extremely necessary to live a basic life.

2) Discretionary: Shopping, Gadgets, Entertainment, Vacation & Travelling. These costs are discretionary in nature & can be avoided in case there is a dent on regular income.

3) Fixed financial commitments: EMI of home loan, personal loan, vehicle loan, building maintenance, payment of insurance premium & taxes. These costs are in the nature of external liabilities & have to be paid on timely basis to avoid defaults.

One can cut down on discretionary expenses in case there is an emergency. However, it is not possible to cut down on necessities & fixed financial commitments. Hence, ones plan should be to build a corpus to ensure necessities & financial commitments are taken care of.

Before we begin with the numbers, Keep in mind that these numbers can vary from person to person. You can have a more conservative approach or aggressive approach. However, it is always good to have a little more cushion than not.

Case I: Mr. A is 24 years old (unmarried & no dependents), earns a salary of Rs. 60,000/month with following expenses:

- Necessities: Rs. 8,000 per month for hostel rent & food expenses

- Discretionary: Rs. 5,000 per month on entertainment & sports

- Fixed financial commitments: Rs. 5,000 per month of EMI for his mobile phone

Mr. A should have a minimum of six months of expenses relating to necessities & fixed financial commitments set aside as emergency corpus. This comes to Rs. 78,000 (Rs. 13,000 X 6 months). In case of Mr. A, there are no dependents & very less financial commitments as compared to his income. Also given his young age, it would be relatively easy for him to switch jobs quickly even if he loses one.

Case II: Mr. B is 35 years old (married & 2 kinds), earns a salary of Rs. 2,50,000/month with following expenses:

- Necessities: Rs. 75,000 per month

- Discretionary: Rs. 25,000 per month

- Fixed financial commitments: Rs. 100,000 per month of EMI for his home & vehicle loan

Mr. B should have a minimum of twelve months of expenses relating to necessities & fixed financial commitments set aside as emergency corpus. This comes to Rs. 21,00,000 (Rs. 1,75,000 X 12 months). In case of Mr. B, there are dependents as well as very high fixed financial commitments. If it is to be assumed that he is the sole earning member in the family then it would be logical to be conservative & keep 12 months expenses as emergency corpus.

The emergency can also arise in form of unforeseen medical emergency. We have seen cases during 2020 where households have lost their savings due to covid treatments. One should always get a health insurance for the family to ensure such situation doesn't arise. Let us understand why it should be a priority to get health insurance to save oneself from such rout.

In above Case I, Mr. A is 24 years old. Assuming he has no pre-existing diseases, a health insurance of Rs. 5,00,000 would cost him around Rs. 4000 - Rs. 5000 annually. This premium should be included in fixed financial commitments & should be regularly paid to ensure that your savings are protected in case of medical emergency & medical expenses are being taken care of by your health insurance company.

I would leave you with a famous quote by Benjamin Franklin - "By failing to prepare, you are preparing to fail". Similarly, by failing to plan your emergency corpus, you are preparing to face a shock in case the emergency strikes.

 

CA Rohit J. Gyanchandani is Managing Director, Nandi Nivesh Private Limited, A Pune based Wealth Management Company.

First Published: 07 May 2022, 03:00 PM IST