Q. What is an emergency fund?
A. An emergency fund is an essential part of personal financial planning that provides a financial cushion in case of unexpected events. The emergency fund, also known as a contingency fund, is actually the most crucial financial goal that you should consider even before planning for other financial goals. Occurrence of unforeseen circumstance can lead to emotional and financial risks and this makes it imperative to plan for an emergency fund.
Q. What are the situations for which I must have an emergency fund?
A. Some of the common situations which require you to have an emergency fund are:
Job loss: Losing a job unexpectedly can cause you financial hardship. An emergency fund can help cover essential expenses, such as rent/mortgage payments, utilities and food, until you secure a new job.
Medical emergency: Unexpected medical expenses can quickly add up and put a strain on finances. Even with health insurance, there may be out-of-pocket expenses that can be challenging to pay. An emergency fund can help cover these costs.
Unexpected home repairs: Home repairs, such as a leaky roof or broken refrigerator, can be costly but require immediate attention. An emergency fund can help cover these expenses without having to resort to credit cards or loans.
Car troubles: Car repairs, such as a broken transmission or engine failure, can be expensive and unexpected. Without reliable transportation, it may be challenging to get to work or take care of other responsibilities. An emergency fund can help cover these expenses.
Unplanned travel expenses: Sometimes unexpected travel expenses can arise, such as attending a family member's funeral or a friend's wedding. With an emergency fund in place, you can cover these expenses without having to sacrifice other financial goals, such as saving for retirement or paying down debt.
Q. Why should I have an emergency fund?
A. Here are some valid reasons to build an emergency fund:
• To meet expenses during uncertainties: Life is unpredictable and you never know when an unexpected expense might arise, such as a medical emergency or job loss. An emergency fund can help you cover these unexpected expenses and provide financial stability during difficult times.
• For peace of mind: Emergencies can hurt your finances and cause stress. Knowing that you have a financial safety net can give you peace of mind and reduce stress. With an emergency fund in place, you'll be better equipped to handle unexpected events.
• For the safety and security of your family: An emergency fund can provide a safety net not just for you, but also for your family. In case of a financial emergency, you'll be able to cover necessary expenses without having to worry about the financial well-being of your loved ones.
• For avoiding bad financial decisions: In case of emergencies, you may be tempted to access cash quickly through borrowing which often involves additional costs such as interest, fees and penalties. These costs can add up over time and end up costing you more in the long run thus hurting your future financial goals. By having an emergency fund in place, you won't need to resort to borrowing in any form be it cash, loans or credit cards.
Q. What are the negative effects of not having an emergency fund?
A. Creating an emergency fund serves as a financial shock absorber during times of crisis, providing a cushion of funds to alleviate monetary stress and ease emotional turmoil. While it may be tempting to source funds from various avenues such as personal loans, credit cards or borrowing from family and friends, such methods carry their own costs and obligations.
Similarly, drawing funds from retirement savings plans or education plans can also have negative implications on these financial goals. The goal of an emergency fund is to avoid going into debt during a crisis while maintaining a stable financial foundation.
Q. What factors must I consider while determining my emergency fund?
A. It is generally recommended to have an emergency fund equivalent to at least six months of your expenses. However, this should be considered as a minimum, and you may need a larger cushion for unforeseen emergencies depending on your personal situation. Some factors to consider when determining the size of your emergency fund are:
• If you have a single source of income or only one earning member in the family, you should maintain a larger emergency corpus compared to families with multiple sources of income or multiple earning members.
• Analyze your monthly expenses over the past few years to determine how predictable they have been. If they have been variable due to health issues or other reasons, you may need a larger buffer.
• If you have significant debt obligations with high Equated Monthly Instalments (EMIs), you should have enough emergency funds to keep servicing those obligations if your income is temporarily affected.
• You may also choose to include lifestyle expenses or budget for your Systematic Investment Plan (SIP) amounts in your Emergency Fund, to ensure your investments remain uninterrupted even if you lose your job.
• It's important to prioritize safety and stability over returns when investing your emergency corpus. Look for products that offer surety of your capital even if the returns are lower.
Q. How much emergency fund should I ideally have?
A. The appropriate size of an emergency fund depends on your age and monthly expenses or standard of living. If you are a young salaried person with medical insurance, then having 3-6 months' worth of your family's monthly expenses would be sufficient.
However, if you are retired or nearing retirement, you may need to have an emergency fund of 6-9 months' worth of expenses in order to maintain the same standard of living and cover the rising costs of medication that typically accompany old age. Thus, the size of your emergency fund should reflect your current financial situation as well as any additional financial risks that may come with age. By assessing your needs and planning accordingly, you can ensure that your emergency fund is adequate to cover unexpected expenses and provide peace of mind.
To be on the safer side, it is advisable to aim for an Emergency Fund that can cover at least a year's worth of essential expenses. If this amount seems unattainable, consider building it up gradually over time.
Q. Can I keep my emergency fund in my savings bank account or fixed deposit?
A. A savings bank account may offer you an interest rate of 4-6% per annum and fixed deposits can offer slightly higher rates of 7-9% per annum. When building an emergency fund, it's important to choose investment options that allow for easy and penalty-free withdrawal. However, in case of an emergency where you may require your funds before maturity, you have to pay a penalty for premature withdrawal of fixed deposit. It is best to keep emergency funds in a separate account and not mix it with your regular bank account.
Q. Why should I keep emergency fund in a separate account?
A. To avoid spending your emergency fund on unnecessary things, it's best to keep it out of immediate reach. The saying "out of sight, out of mind" is true in this case. If you have easy access to the amount, you may be tempted to spend it on things like a fancy dress or a new electronic gadget. By keeping it in a separate account, you'll be able to track how much you have saved and how much more you need to save. This way, you won't be able to spend the money on a whim, no matter how much you may want to.
Q. Where can I park my emergency funds?
A. It's important to remember that an emergency fund should be easily accessible, and choosing an appropriate investment option can help ensure that you have the necessary funds available when you need them. Ideally your emergency fund should consist of multiple layers. Initially, keep a portion of the funds in cash at home, followed by some in a savings account or sweep-in fixed deposit and finally, you can choose to keep a portion in either overnight funds, liquid or ultra-short-duration funds or money market funds which are low-risk and liquid investments. It is thus recommended to have a layered safety net.
Q. Why should I park my emergency fund in an overnight or liquid fund?
A. Overnight mutual funds primarily invest in short-term assets and securities with the majority of their holdings in cash at the start of each business day. These funds are open-ended and allow you to enter or exit them by submitting redemption requests before the cut-off time on working days.
Liquid fund, on the other hand, primarily invest in money market instruments such as treasury bills, term deposits, certificates of deposit, commercial papers, inter-bank call money and government securities which minimize volatility as compared to debt funds with longer portfolio durations and ensure high liquidity. These instruments have a residual maturity of less than or equal to 91 days and thus carry low risk. Liquid funds are designed to provide superior liquidity with the flexibility for premature withdrawal and can also offer slightly higher returns compared to fixed deposits. By investing in liquid funds, you can ensure that your emergency fund is readily available when you need it, without having to worry about market fluctuations or penalties for early withdrawal.
Q. Can I invest in equity as a part of my emergency fund?
A. You must realize that you create an emergency fund for your financial stability and security and not for wealth creation. Therefore, the primary focus should be on safety and liquidity. Some investors make the mistake of investing their emergency corpus in equity mutual funds in the hopes of achieving higher returns, but later face difficulty when they need to withdraw the funds. Equity is not recommended for an emergency fund as the market is volatile and selling during a downturn could result in losses. Similarly, investing in instruments which have a specified lock-in period such as PPF, EPF or ELSS should also be avoided. It's better to invest the emergency corpus in a liquid fund, overnight fund, ultra-short term bond fund, or bank fixed deposit as discussed above or in a combination of these investments.
Q. What are the different instruments available for investing emergency corpus?
A. The following table provides you a list of suitable and unsuitable instruments for parking your emergency corpus:
Suitable for Emergency Fund | Not Suitable for Emergency Fund |
- Savings Bank Account | - Equity |
- Fixed or Recurring Bank Deposits | - Equity Mutual Funds |
- Overnight Funds | - Real Estate |
- Ultra-Short Duration Fund | - Fixed Return Instruments like PPF, EPF |
- Liquid Funds | |
Q. How can I calculate how much emergency fund I need?
A. You can calculate your emergency fund as follows:
Emergency Fund = Monthly Expenses including (Rent or EMIs + Utility Bills + Groceries + Transportation + Miscellaneous) X 6 months |
Q. Should I pay off my debt before providing for emergency fund?
A. It's a common dilemma to choose between paying off debt or building an emergency fund. However, you must understand that while debt repayment is important, unexpected expenses can arise at any time, making it crucial to have an emergency fund. Therefore, it's advisable to prioritize both financial goals simultaneously. If you must choose between the two, it's recommended to build an emergency fund first. This way, you can ensure that you have a financial safety net in case of any unforeseen circumstances.
It is also important to remember that even if you have debt, you can still contribute a small amount towards your emergency fund each month. Once you have built a sufficient emergency fund, you can focus on aggressively paying off your debt.
Finally, the decision of whether to pay off debt or build an emergency fund depends on your individual circumstances. However, it's always better to be prepared for unexpected expenses and have a financial safety net in place.
Q. Do I need to assign nominees like any other investments while setting up my emergency fund?
A. It is important to ensure that nominees and joint account holders are designated when setting up an emergency fund. This is to ensure that the funds can be easily accessed by you and your immediate family members in times of need. Failing to designate authorized persons could lead to difficulties in accessing the funds when they are needed the most.
Q. When should I use my emergency fund?
A. Ideally, an emergency fund should be utilized as a last resort when all other options are exhausted. The purpose of an emergency fund is to cover unexpected expenses that cannot be covered through regular income or savings. Typically, an emergency fund should be used in situations where the primary earner of the family faces a medical emergency that or job loss, either temporarily or permanently. This fund is intended to cover monthly expenses such as school fees, food and other living expenses, so that the family can maintain their current lifestyle until the primary earner recovers from the emergency. It's also important to note that an emergency fund should not be used for discretionary expenses or non-emergencies. By using the emergency fund only when necessary, you can ensure that it remains intact and available for future emergencies.
Q. What should I do if my emergency situation exceeds the amount of my emergency fund?
A. Experts suggest that redeeming investments should be avoided when in dire need of cash. Taking a personal loan should also be avoided due to high-interest rates, which typically range from 12 to 18 percent. If you already hold mutual funds, you can take a loan by keeping them as collateral to meet your emergencies. In this case, the interest rate is usually around 9-10 percent, which is lower than personal loans. By taking a loan on mutual funds, you can save on interest rates and potentially earn long-term returns of around 12 percent in the equity markets. However, if you don't have enough invested in mutual funds, you can take a loan after taking into consideration the period of requirement and the applicable loan rate. Always keep in mind that you should consider redeeming investments only as the last resort when the money requirement exceeds the emergency fund.
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