I am sure we all have heard this phrase quite often in our lives. But the question is why should one be prepared for adversity? Let’s look at an example.
My father always reminds me to wear a helmet whenever I ride a two-wheeler. He also follows the rule that a pillion rider must wear a helmet (I must admit here, that I hate to wear a helmet as it messes up my hairstyle).
One fine morning, my dad had to drop me to college. Both of us wore our helmets and left our home. On our way, we were hit by an auto. The auto driver was trying to avoid a cop and took the road which was one way and collided with us.
The cop caught the auto driver. My dad and I escaped with a few bruises. I must admit the helmet came to our rescue. If not for the helmet, I would have hit my head on the divider. It’s better to be protected because like Ceat Tyres say “The Streets are filled with idiots”.
I also remember my father’s advice “Save money for the rainy day”. We all want to stay away from risk and be well prepared for an unplanned event, right? The same applies to our money or hard earned savings. The common fear amongst people today is that they hesitate to look into long term investments. They feel that if their money is locked up in a long term investment, it prohibits them to use their own money during an emergency. This is definitely a genuine reason to be afraid of. Situations such as accidents, health issues, job loss, etc. are uninvited guests and one needs money in terms of liquid cash to be able to face such situations. Hence people avoid long- term investments and resort to more liquid instruments such as bank deposits so that they are able to use their money when they need it.
But does that mean one can never invest in long-term investments? The answer is NO; there are indeed other ways one can invest in order to set aside money for emergencies.
Thus, arises the need for an “Emergency Fund”.
We typically need emergency funds for two reasons:
- for planned events which are under our control.
- unplanned events which are definitely out of our control.
For example, House Rent is an expense that you would have every month and for fixed intervals. Similarly, expenses like servicing a car/bike, EMI, School fees, etc. are events that can be forecasted and one can control the nature of these events by having a well-structured budget plan.
But what happens in situations that are uncalled for? Like an accident or a medical emergency. These situations are likely to happen and without an emergency fund, one is seldom prepared. Let’s take the example of the 2018 Crisis caused in Kerala due to the unusually high rainfall during the monsoon season. Who would except thirty-five out of the fifty-four dams within the state to open for the first time in history? The situation was declared as Level 3 calamity meaning, “calamity of a severe nature”. Many people lost their lives and their properties to these floods. Most parts of Kerala required and still requires massive restructuring in terms of infrastructure. To face such situations it is always important to have emergency funds.
But this fund will be used only in case of a financial crisis and you will not access it until the need arises, meaning one cannot use it for a planned event such as the down payment of the house. This is only for unexpected and crucial emergencies.
A friend of mine recently switched jobs. A job that he had been dreaming to join for quite some time. His joining date was in another week or so. Even though he had savings from his previous employment and with the hopes of a better salary from new employment, he bought a four-wheeler on a bank loan. To his surprise, the company he was supposed to join went on a hiring freeze and informed him that there would be a huge delay in his date of joining. And once the freeze was removed they would consider his employment again. This was a situation which was clearly uncalled for. This meant that he had to take care of all his expenses and the EMI with the savings from his previous employment, which was not much.
Situations like hiring freeze don’t happen often. They are events not anybody would want to face, but one doesn’t have a choice.
My friend managed to borrow some funds from his family, cut down on his expenses, forwent few Friday parties and paid his EMI on time. After about 3 to 4 months, his job started and his life was back to normal.
An emergency fund acts as an oxygen mask during such situations.
But how much do I need to set aside in an emergency fund?
I’ll answer this question with a help of a table.
|Your situation||The amount to set aside for Emergency Fund|
|Single and no dependents||6 months’ living cost|
|Double income family (you and your spouse both are working) and no dependents||3 months’ living expense|
|Single income family with dependent parents and children||A year’s living cost|
Living cost here includes everything like rent, EMI, school fees, utilities, premium, credit card charges, club memberships, and many more. Remember these are only average estimates, one’s need can always differ from another based on personal situations, so you can increase or decrease the amount as required.
If your family is risk-averse and then it’s best to make it a habit to keep a year’s expense as an Emergency Fund.
Where do I keep this money?
The point of emergency fund is that it is easily accessible. One option could be Savings Deposit, but make sure that it has a sweep-in feature. An account with the sweep-in feature will earn you more interest than the normal savings account which is between 3.5% to 7%. The point to be taken into consideration is “Liquidity of the funds”. You need to move it to a place where it is not easy to access the money and resist the temptation of withdrawal, at the same time it must fetch you good returns and must be liquid enough to access it.
People usually pick the option of Fixed Deposits. Fixed deposits are safe and reliable. They provide you fixed returns on a fixed interest rate. Speaking about liquidity, Fixed Deposits are not very flexible. Fixed Deposits come with a maturity period. The money deposited in the bank cannot be withdrawn until the tenure is completed. If you wish to do a premature withdrawal due to an emergency or need, then you will be subjected to penalties, hence losing a portion of your gain. Also, the amount earned from Fixed Deposits is taxable depending on the current tax slab that you fall into. However, certain banks provide Flexi – Fixed Deposits, allowing you to take the amount you need rather than breaking the entire deposit. The alternate option is to split the emergency fund into smaller Fixed Deposits, thereby you don’t lose the interest on the entire deposit.
Another wise decision would be Short Term Debt Mutual Funds. Mutual funds are an investment vehicle that pools in money from small investors and invests the money in the securities market. In particular, Short term debt mutual funds have a maturity period between 1 to 3 years. Considering the fact that if your new to mutual funds, then short term funds provide lower returns but are less risky compared to the equity funds.
Another option could be an investment in a Balanced Fund. One can invest a larger portion, say 70% in bonds and 30%, the smaller chunk in stocks (the percentages can vary as per your need and risk appetite). Thereby increasing the chances of receiving higher returns and managing the risk too.
All said and done. Needs differ so does Risk Appetites. One has to look into the extent of risk one can take and then choose the ideal amount to set aside as an Emergency Fund.
The easy method is to set a monthly target for your emergency fund and keep crediting your emergency account or provide standing instructions to your bank for the same. Upon reaching the desired amount required for an ideal Emergency Fund, you can stop funding it.
Where do I keep the surplus money?
Once you have set aside and planned your emergency fund, the surplus that’s left can be used to invest in long term investments. Any investment for more than 5 years has to be made in Equities because equities perform best when you remain invested for a long period.
“The market is volatile, I don’t want to risk it!” is this the problem? Well to address this concern Finity provides 3 thumb rules:
- For emergency funds, consider putting the emergency corpus in portions of Liquid Funds and Savings Account (with Sweep-in feature).
- If you require money in the next 3 – 5 years, then you must put them in Government fixed income instruments or Debt Mutual Funds.
- If you require money anytime after 5 years then you must put the money in diversified Equity Funds or Balanced Funds.
These rules don’t just help you with managing your personal finance, but also makes sure that your not placing all the eggs in the same basket i.e. you are diversifying the risk by placing your investment in various instruments as per your goal. Also, the advantage of mutual funds is that your investments are controlled and monitored by an Expert/ Professional Fund Managers. They help you in managing your mutual funds and also rebalance the investment portfolio regularly.
So hope this article helped in understanding the need to have an Emergency Fund. Remember its important to plan your finances rather than delaying your investments due to the fear of risk.