In bad times, it will act as an emergency fund to tackle serious problems.
Emergency funds can be easily counted as one of the most and conveniently ignored aspect in an individual’s financial situation. People prefer to wait for emergencies to happen and then scamper to meet the financial obligations arising out of an emergency, rather than plan for the same and be able to better manage the situation.
An emergency fund is definitely one of those key components in a financial plan that needs to be sorted before one embarks on savings and investments. However, it is observed that people generally have high appetite and understanding towards saving for goals than having an emergency fund at their disposal.
Necessity for an Emergency Fund
The word emergency leads to visualising negative events like hospitalisation for a serious illness, loss of property due to fire or other natural calamities, a sudden major expense and so on. While one is in the middle of a crisis, it will be really difficult for an individual to think of a financial rescue plan, a way out of these events. There is no doubt, that most of us will think of a personal loan at the time that emergency strikes. Should we create an adequate emergency fund at disposal, we will never end up paying the high interest rates that personal loans charge us.
While it is important to provide for such events, one has to also look at the other side of the coin. Events such a sudden fall in equity markets, properties available at bargain prices, attractive holiday packages available at discounts are also potential realities. The emergency fund could definitely be utilised to cope with these events too.
Well, one of the most recent examples of an event that has both positive and negative sides of an emergency to it is the increase in interest rates. The rise in equated monthly installments (EMIs), along with the rising inflation, has definitely put a dent to many household budgets. An emergency fund could definitely be useful in such a situation to tide over the burden of the additional EMIs till the time rate hikes take a breather. On the other hand, with banks and companies offering attractive rates on deposits, the funds available in the emergency fund could also be utilised to lock-in money at higher rates.
Size of the emergency fund
Typically, as a thumb-rule, it is recommended that this fund should be worth at least six to eight months of living expenses of a family. However, some guidelines that may be kept in mind for calculating the quantum of this fund could be as follows:
Committed monthly expenses
Determine the total committed expenses for a month which would include rentals, groceries, food expenses, utility payments, credit card rolling payments, children education expenses, loan EMIs. The other discretionary expenses, like eating out, shopping and entertainment should also be considered.So keep anywhere between 50 - 70 per cent for the purpose of calculating the emergency fund. While it may be easy to disregard discretionary expenses totally in theory, the same may not be practically possible. Thus, the above range should be reasonable enough if one has a more defined and stable income source, like a well paying job.
But, if the income is irregular or volatile, the fund size may have to be increased. One needs to take into account the fact, that there may be periods when nothing can be added to the fund even as there are debits from it.
Liquid savings available
The balances available in one’s savings account or similar accounts, which can be withdrawn on demand, also help in deciding on the quantum of this fund. The higher the amount of saving balances available, lower would be the fund required.
In addition, to the above it would be worthwhile to take stock of any emergencies that may have occurred in the last three to five years and accordingly budget for this fund. Those who have had a health emergency may face a relapse that requires hospitalisation.
It may be noted that while prioritising for goals, an emergency fund should always be at the top priority, even at the cost of not meeting saving targets for goals.
Maintaining the fund
Returns and emergency funds should be kept separate. In other words, it is advisable to not optimise returns on these funds. Any returns earned on these funds have to be treated as bonus money. What is more important is to ensure that in times of emergencies, the principal amount invested in an emergency fund should be available in entirety. It is important that this fund be liquid. Accordingly, it is advisable to maintain emergency funds in the form of bank deposits, preferably, in a bank located closest to one’s residence. It would be pertinent to note that a small part of this fund should be maintained in the form of cash at residence as not all emergencies may provide time to visit the bank and withdrawing cash.
Building the fund
Not every individual would have the privilege to set aside a lumpsum amount towards this fund. The same could be built in a systematic manner, although a lumpsum approach would always be preferred for the reason that emergencies may not come in piecemeal. Slow and methodical payments too would help in building this reserve. Based on the monthly budgets and financial plan, a fixed target can be set and kept aside every month into a separate account. These small payments can be accumulated into a fixed deposit once every quarter or half year depending upon the amount in question.
Once the desired amount of fund is reached, it is also important to leave this fund on its own. Temptations to dip into this fund to buy that electronic item or splurging on a holiday should be strictly avoided. Equally, one should avoid the tendency to use this fund to prepay loans, unless the same is extremely urgent. Building a savings plan to foreclose debt is a far safer strategy.
Once on course, it is also necessary to review the fund every year and revise its quantum based on the expense levels and requirements. An emergency fund can never be static.
Hopefully, situations where emergency funds are required to be tapped should never arise. In any case, if it were to, then having a fund in place will help.
The writer is certified financial planner
