The ongoing coronavirus pandemic has hit India’s economy hard, triggering a credit crunch for many. The calamity has made many people realise the importance of having an emergency fund. A contingency fund or an emergency fund is a specified amount set aside for emergencies that arise unexpected. These can be medical emergencies, temporary job loss, pay cut or unexpected travel due to family emergencies.
What is an Emergency Fund?
An emergency or contingency fund, as the name suggests, helps you and your family to financially face a medical scare, unavoidable household repairs, sudden loss of job or salary or pay cut or something that impacts the community at large such as wars, social unrest or a pandemic like the current one.
Importance of an Emergency Fund
Life is full of unexpected situations good and bad. Hence, apart from other things, you need to be prepared for it financially. While you can plan for some foreseeable expenses, an emergency fund can help you manage all unplanned expenses efficiently. The current pandemic is an example of one such unplanned expense.
People with an emergency fund are in a much better position to manage this lockdown than those who don’t. During financially difficult times, an emergency fund can help you stay afloat without having to rely on credit cards or loans. If you already have loans that you are paying off, then an emergency fund can help you avoid borrowing more.
How to set an Emergency Fund?
For starters, the first step is to estimate how much money is required to meet any sort of emergency. Every individual has different financial needs. Hence, the amount will vary for all.
Before calculating the amount of the emergency fund, it is important to calculate the minimum amount one needs to get through the unavoidable monthly expenses. This should include house rent, insurance premiums, loan installments, utility bills, groceries, etc.
An emergency fund should be enough to fund the monthly expenses for up to 6-8 months, or up to a year if an individual fear a job loss or feel things are uncertain on the financial front.
How much Emergency Fund do you need?
Every individual has different financial needs. Each individual has a unique combination of lifestyle, dependents, income, and unavoidable expenses. Hence, the figure will be different for all. Before calculating the amount of the emergency fund you need, it is important to calculate the minimum amount you need to get through the unavoidable monthly expenses. This should include house rent, loan installments, utility bills, etc. Ensure that you don’t include avoidable expenses that movies, travel, etc. in this amount. Once you know your monthly expense, try to create a cash fund that can help you survive three-six months without any income. Given the current situation, most people will agree that six months of basic living expenses stashed as an emergency fund is a must at all times to manage exigencies efficiently.
How to manage an Emergency Fund?
Just saving up some money is not enough. Just as you strategize to save for the goal, you need to have a plan for its deployment and use.
There are three crucial aspects to look at when deploying an emergency fund: security, accessibility, and liquidity.
- Security: The money in this fund is to help you through a tough situation; hence, you cannot deploy it anywhere where there is risk of capital erosion in the short term. Equity/ equity-based mutual funds or any other option with a proportionately high risk should be avoided.
- Accessibility: Most emergencies strike fast. If you do not have timely access to your emergency fund, it is pointless. Ensure that the funds are conveniently accessible so that you can take care of immediate expenses.
- Liquidity: Liquidity refers to how quickly your investments can be converted to cash. Long-term deposits, bonds, Provident Fund (PF), National Savings Certificate (NSC), etc. do not work as they are either irredeemable before maturity or have an upper limit on withdrawals.
- Keeping these factors in mind, you can try the 15:15:70 method for deploying your emergency fund.
- Cash: Keep 15% of the money in liquid cash. Keeping too much cash is not recommended from a safety point of view. Additionally, over a period of time, idle cash loses its value due to inflation and rising cost of living.
- Bank Deposits: Another 15% could be held in your bank account securely. It takes away the risk of spending the money and the funds will earn a small interest on the savings bank account.
- Cumulatively, this 30% of your emergency fund provides quick access for immediate use and for smaller emergencies.
- Investment: The balance 70% of the fund can be invested either in short-term deposits or liquid mutual funds. Both these debt instruments have minimal risk, and they are highly liquid, too. Your investments can be liquidated through the fund house or bank’s app or a physical request, and the funds will reflect back into your account within a day or two.
Where should one Invest?
Emergency funds must be readily accessible; therefore investors should necessarily invest in liquid instruments.
Liquid instruments offer unhindered access to fund.
Since emergency funds are designed to cover emergencies, one shouldn’t let this corpus be influenced by volatility. Asset allocation, hence, should be done in debt and money market securities.
Here are the options one can choose from:
- Savings Account
People who are not comfortable with debt instruments can use savings account that offer a high rate of interest with no minimum balance requirements for parking emergency fund.
- Flexible bank Fixed Deposits (FDs)
FD, being a secure investment, can also be used as an emergency fund investment. In any unforeseen requirement, fixed deposits can easily be converted to ready cash.
- Liquid Funds
Investors can park around 30-50 percent of the investible corpus in liquid funds as they offer high liquidity along with better returns than a savings account.By investing a sizeable part of the emergency fund in these schemes, liquidity is ensured since investors can redeem within a couple of days. Average returns on liquid funds hover around the 6-8 percent mark. With low risks and an opportunity to earn good returns, these funds can help in creating the corpus in a shorter period.
One should consider starting a systematic investment plan (SIP) and automate savings and investments.
How to build an Emergency Fund?
Putting aside a couple of lakhs may seem like a gargantuan task, but with a little planning, financial prudence, and a step-by-step approach, you can easily get there. Here are some quick tips on how to get the ball rolling:
- Set a monthly goal: Once you decide the amount that works best for you, stagger your goal into smaller palatable monthly deposits. This puts you into the habit of saving and makes the task a lot less daunting.
- Use a separate account: This should be parked with the principle of out of sight, out of mind – this way you are unlikely to get tempted to spend that money. Ideally, park the money in short term debt funds known as liquid mutual funds.
- Pay your future self-first: Just as you strategize for other financial goals such as planning for retirement or saving up for a home, put aside a small amount every month as soon as you receive your salary/ draw your business income. If possible, automate the transfer so that your savings are taken care of on a priority.
- Trim your expenses: Reigning in on the non-essential expenses mentioned earlier will allow you to get to your saving goals quicker, and maybe even increase the monthly allocation. You don’t have to go absolutely cold turkey, but just prioritize your expenses. Instead of eating out on a weekly basis, cut it down to one or two outings a month, watch movies at home, limit non-discretionary online shopping, etc.
- Reallocate lumpsum receivables: Have you received a bonus at work, got a tax refund, or an envelope from an aunt on your birthday? Set aside a small amount to enjoy yourself, and allocate the rest to your emergency fund. Adding any windfall gains can really help fast-track your goals.
Where should you keep your Emergency Fund?
Once you have finalized the amount of the emergency fund you need to build and start working towards saving it, it is important to find a good place to keep it. A savings account is a logical choice since it offers liquidity that is highly important during a crisis. You can look for a savings account offering a high rate of interest with no minimum balance requirements or heavy fees. However, another important aspect of an emergency fund is that you will not need it regularly. Hence, rather than accepting the returns offered by a savings account, you can consider investing a part of this fund in an instrument that offers high liquidity and returns better than savings accounts.
Some mutual funds offer easy liquidity and better returns than savings accounts while keeping risks minimal. These are liquid funds. By investing a sizable part of the emergency fund in these schemes, liquidity is ensured since you can redeem within a couple of days. Average returns on liquid funds hover around the 6-8% mark.
Another important aspect of an emergency fund is building it. Let’s say that your basic living expenses are Rs.40,000. Therefore, you will need to save between Rs.2-2.5 lakh as your emergency fund. Considering the increasing costs of living, this can take time. You can reach this goal faster by using a debt mutual fund. With low risks and an opportunity to earn good returns, these funds can help you create the corpus in a shorter period. You can consider starting a systematic investment plan (SIP) and automate your savings and investments. You can also invest your annual bonus in these funds to reach the target sooner.