Emergency fund is one of the first Must Do Activities any individual should do before starting investing. But most of the time we forget to plan and as well as implement it. One should give importance to the emergency fund as it is a first step of financial planning. This emergency fund should be in very liquid form so that it is instantly accessible.
What is an emergency fund?
Emergency fund is a kitty which has been kept aside to face any unforeseen event in the future. The events could be job loss, sudden decrease in income, sudden financial liability or temporary income stop due to temporary disability.
What is the purpose of an emergency fund?
It mainly provides peace of mind to the individual. It gives surety that the individual is well-prepared in the short term to face any financial crisis. It also gives financial security by creating a safety net of funds for such expenses. If the individual has an emergency fund, he has not had to dig into his long-term savings.
What should be the size of the emergency fund?
• Thumb rule is that one should have 12 months of his monthly expenses plus going on EMIs as his/her Emergency Fund.
• But if the investor has a stable job, good savings and controlled expenses he can set aside 6 months of his monthly expenses plus going on EMIs.
• If your spouse is working and you consider that job can cushion you in any shortfall of your income then 3 months of his monthly expenses plus going on EMIs. is sufficient as an emergency fund.
For Example:
• Suppose Ajay is in an IT firm earning a handsome salary, and he can save up to 40 % of his salary then he can save 6 to 9 months of his monthly expenses as Emergency fund. In this case let us assume Ajay’s monthly expenses is 40000 and home EMI is 40000 then he should have 6 months expenses+home EMI as his emergency kitty i.e. ₹48,0000 to ₹7,20,000.
• Suppose Radha and Jay both are in retail industry and draw approximately the same amount as salary they can have 4 to 6 months expense as emergency fund. If their monthly expenditure is 50,000 then ₹2,00,000 to ₹3,00,000 will be sufficient as an Emergency Fund..
• But due to Covid pandemic we experienced that it is always better to have an emergency fund upto 9 to 12 months which may be helpful as a medical emergency as well.
Emergency fund and Investment should not be mixed at any cost. Never consider the money kept aside as an emergency fund as your investment. You should not map it with any of your goals. One should always update their emergency kitty from time to time, whenever your expenses increase.
Emergency fund is a mandatory EXPENSE which you should incur and forget.
Many times youngsters have this question in mind as whether they should fill up their emergency fund first and then go for the investment. The answer to this question is not very straight. It all depends on your current financial situation such as how much you earn, how much are your expenses, how secure is your job or profession you have taken up, how much family responsibility you are carrying and how much loan/debt you are carrying.
A youngster with no family responsibility, financially independent parents, having no loans with low expenses and a secured job can start with 50% allocation with emergency fund and 50% for long term goals. This way s/he can simultaneously build long term wealth along with taking care of any unfortunate event.
But if you have dependent parents, your monthly expenses are more , you have any loans like education loan or personal loan and you are not sure of your job income then better to fill up the emergency fund first asap and then focus on other financial goals. This way you will have peace of mind of having liquid cash parked for any unforeseen events.
Where to park your emergency fund?
Most important aspect of the emergency fund is it should be easily accessible at the time of emergency. Liquidity is the highest criteria. Second one could be Capital Protection. Whatever money we are keeping aside should be safe at all times. Third, this money can earn a reasonable return.
Following are the most preferred financial products used for emergency fund.
1. Cash: Many people keep on hoarding cash at home for emergencies. This is an age-old style of households. But it carries risk of theft, wear and tear and most importantly decreasing its value over time due to inflation. Keep cash only for your usual expenses, not more than that.
2. Bank saving account: This is another option for many investors. Here the possibility of theft and wear and tear is taken care of but what about returns on saved amount? If the inflation is considered as 6-7% your amount in bank saving amount is eroded as you can earn only 3%.
3. Bank fixed deposit: This is one of the recommended options for emergency fund. You can park your amount here which provides liquidity, safety and as well as higher return as compared to a bank saving account. You can link it to FD. But only FDs are still not suitable for the highest bracket tax payers. Its post tax return drastically decreases for 30% Tax bracket investors.
4. Recurring deposits: RDs in banks can be a recommended option for building an emergency fund over some years. If you don't have a sizable amount to do as FD you can start RD for one year and after its maturity convert it into FD. Again start RD for a year and convert it to FD. You can do it until you accumulate the targeted amount.
5. Liquid funds: This is the most suitable option for any investor preferably to the highest tax bracket investor. Liquid funds are simply debt mutual funds that invest your money in very short-term market instruments such as treasury bills, government securities and call money that hold the least amount of risk. The rate of return of liquid funds is always better than FD and RD. One can withdraw some amount instantly too. The full amount can be liquidated in a day’s time. It offers better taxation than FD if held for more than 3 years for higher tax brackets.
6. Credit card limit: Modern investors consider credit card limits as their emergency fund. If you have a good credit history and use credit cards extensively, the bank offers high credit limits. In case of emergency, you can just swipe the card and get it solved. But this is not a recommended option by me because if you are not able to pay the credit card amount you have to pay hefty interest on it and you can get trapped in new debt.
Personally, I keep 9 months of my monthly expenses as emergency fund. I prefer a combination of liquid funds, fixed deposits and recurring deposits and some amount in a savings bank account.
Preeti Zende is a SEBI registered Investment Adviser and Fee only financial Planner. She is Founder and owner of Apana Dhan Financial Services, Associate of Insurance Institute of India.