Basics of Emergency Fund


An emergency fund is a stash of money set aside to cover the financial surprises life throws your way. These unexpected events can be stressful and costly.

We don’t have to re-invent the wheel by defining what is “emergency”. Everyone understands it.  In simple words, it is occurrence of an unexpected event with adverse impact on our otherwise smooth life.  Such event could be a severe accident, sudden death, unexpected serious illness, physical disability, loss of job with resultant financial uncertainty.  When life presents an emergency, it threatens our financial well-being and causes stress. Any of these can stretch the generosity and finances of families. Each of us will tackle such ‘emergency’ in his / her own way and will definitely tide over it with passage of time.  May be, sometime one just reconcile to a certain kind of ‘emergency’ which comes as ‘fait accompali’.

Nevertheless, it is always prudent to be in readiness, to the extent possible, even for those uncertain events, severity and timing of which we are not able to gauge or assess accurately.  In ‘emergency’ situation, our readiness and ability to address it at least in the initial phase, gives us a lot of confidence towards its ultimate resolution.

When life throws nasty financial surprises your way, have a Plan B ready. An adequate emergency fund can help you tide over the crisis. That is the contingency fund we may have to build for our own happiness

Now find out how big a contingency fund should you have. This question will have to be answered by each one of us in our own way, though there are broad criteria.  In today’s uncertain job market, a lay off can lead to months of unemployment. But anyone with a stable and secured job need not worry too much on this count. On the other hand, Stars, artists and sportspeople typically have very short career spans and irregular income levels and thus would need to factor these to work out the quantum of emergency fund as well as in their overall financial planning. Similarly, one would need to take into account the quantum of EMIs for existing debt servicing as well Insurance premium already contracted.  Besides, if there are certain known regular medical expenses (for an existing chronic illness of any family member).  Lastly, the number of earning members in one’s family as also the number of dependent family members and overall household expense, will all determine the extent of emergency fund which anyone would need to keep aside.

The thumb rule is to keep aside 3 to 6 months of basic life expense and payments.  It is generally experienced that during this period of an emergency situation, a viable alternative is worked out to bring the life back on rails.

In today’s time where health insurance plans are becoming quite popular, need of an emergency fund for medical emergency is diminishing. But at the same time, health insurance is actually available only when hospitalisation is needed. So one will need cash for doctor visits, tests and medicines, prior to hospitalisation.  And cost of these diagnostic tests, sometime, could also be substantial. Some health insurers have started insurance policies for OPD expenses also but one should be careful in weighing the pros and cons of these vis a vis return in liquid funds, as these health plans are currently priced at high premium.

Similarly, credit cards have also reduced the need for emergency funds, as expenses can be paid almost instantly through credit cards.  Credit cards will make us available interest free funds for period up to 50 days, during which alternatives sources of funds could be tapped and credit card bill paid.  However, credit cards should not be seen as a replacement for setting up an emergency fund as these funds would be exorbitantly costly, beyond the initial period of 50 days.

Once the size of this kitty has been worked out, the next question to be addressed is where to invest these funds, without compromising on the key element i..e ‘access and easy availability of these funds at short notice.  Remember, ‘return’ on these funds is of secondary importance.

No financial planner will suggest to keep emergency funds idle.  One should look for options for investing these funds also. One can park at least 25% of the emergency fund in saving bank account, which can be withdrawn 24*7.  Here, ensure you have a debit card with adequate cash withdrawal limit.  Many people remain unaware of their debit card’s daily cash withdrawal limit till the time they attempt to withdraw huge amounts of cash during an emergency.

But savings bank accounts give very low interest of 4% p.a. on the balance (with exception of few private sectors banks now, where it can go up to 6%).  A more remunerative option would be a sweep-in account where excess funds automatically gets converted into a fixed deposit with higher returns of 6-8%.  When you withdraw, the money is paid by breaking the fixed deposits.

The other comfortable option is to park these funds in liquid fund scheme.  The money will earn a decent return and can be withdrawn at any time.  Liquid funds and some ultra-short funds have returned more than 8% over the last one year.  Redemption under these schemes takes a day only.  Some fund house offer liquid funds that come with ATM cards so the investor can withdraw the money directly without the redemption first going to his bank account.

Revisit your emergency fund kitty regularly review it at least once a year.   A contingency kitty once formed is not the end of the process.  Everyone needs to revisit this fund and replenish it regularly to adjust for inflation, lifestyle changes, increase in family members and changes in debt commitments.

Creating Emergency Fund is the first step of a Financing Plan.

  • It helps keep your stress level down
  • It keeps you checked from spending on a whim.
  • It keeps you away from making bad financial decisions.

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Avoid these mistakes

Your best teacher is your last mistake

Financial planning is well adopted and followed by vast majority among developed countries, especially USA and Europe.  In India also it is gaining popularity, gradually and particularly among young population.

Objectives of Financial planning would include building one’s wealth gradually and consistently to reduce financial uncertainties, provide adequately for contingencies & medical emergencies, equip oneself for realising one’s dreams of an own house, children’s education, foreign tours and stress free relaxed retirement life. The exercise would entail setting specific goals, saving regularly, wisely investing those savings, and protecting your assets. This needs to be done on an ongoing basis through various life cycle stages.

There are, however, many common financial planning mistakes that can cause sub optimal results to your money and wealth. Some major mistakes that you should avoid are:

Ignoring inflation

When planning finances, the time value of money, or how money loses its value over time is very commonly overlooked by most. Loss in money value over a period of time is inevitable and the hard reality of financial world. While incorporating increase in income with time, it is vital to consider the increase in expenses and the drop in the value of money thanks to the annual overall increase in prices of common goods and services.

Being over-dependent on “safe” investments such as saving accounts, Bank FDs, and government bonds will lead to your portfolio giving returns at a rate lower than the inflation rate.

Ignore inflation and you might just see your savings slowly erode away while your financial plan goes haywire.

Undervaluing long term expenses when considering retirement

When investing and saving for your retirement, the most important point to consider is the correct estimation of health care and other long term essential expenses, owing to the process of aging. Health care and other costs increase with age, and incorporating these expenses correctly is necessary for an effective retirement plan. Not doing so would compromise your savings and finances during your years of zero income.

Not saving enough or investing when you are young

The initial years of your investing life must be focused on savings. The rate of savings during that time should be more than the rate of returns.

An effective investment plan can be made, gradually, once you are saving consistently and as much as you can in those initial years. Remember, the earlier you start, the more will be the power of compounding.

Savings should be made not just by controlling daily expenditures, but also by considering the money paid towards taxes. Figure out a good plan to maximize your savings during the initial years of your investment life. If you are in a higher income category, tax savings (through correct choice of investments) should be important.

Investing too aggressively or too conservatively

It is very commonly opined that people in the age group of 20-40 years should invest aggressively. Investing more and more is okay but it is also necessary to invest using reasonable logic and not blindly as investments would also entail some risks. One may end up losing more if one exposes to a risk not compatible with one’s goals.  Failure will lead to frustration and moving from investing in future.

Similarly, too conservative investment approach also has its downside. Choosing conservative investment options can lead to loss in the value of your money. Stocking up cash in your savings account will bring down its value over a period of time; inflation would eat up most value of your money, with passage of time.

Hence, it is of paramount importance to choose appropriate investment options with varying degrees of risks so that your money grows consistently.

Thinking that Insurance is about saving tax

Far too many individuals make this common mistake in India. Insurance of any kind is an expense and not an “investment”. Buying insurance (life or health) just to save tax is one of the worst ways you can spend your money, unless you actually need the insurance.

Life Insurance is a must only if you have dependents. Life insurance is much beyond tax saving. Think about the need and utility of life insurance first before you think about the concomitant tax benefits. Life insurance cover at early age gives you benefit of lower premium as well as higher multiplier for maximum cover amount.  At the same time, lower income at young age would cause a lower premium paying capacity.  So plan well and draw a balance. Build up gradually.

Health Insurance in today’s expensive healthcare scenario is a must. With longer life expectancy, its criticality goes up in advance years of life.

Overall, DIY approach is good and economical. It works in financial planning. But there comes a point and stage where someone’s experience can give you better result.

Thinking financial planning is all about investing

A very common misconception is that financial planning is all about investing.  IT IS NOT. One must appreciate that investing is just one part of an ideal financial plan to meet your long term goals.

It is important to focus on day-to-day budgeting, appropriate insurance cover (for everything of real value to you, including your health) and smart tax decisions, to make an effective and appropriately long term financial plan.

So go ahead & choose an experienced Financial Planner

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