Emergency fund is one of the first Must Do Activity any individual should do before starting investing. But most of the time we forget to plan and as well as implement it.. One should give importance to the Emergency Fund as it is a first step of Financial Planning. This Emergency fund should be in very liquid form so that it is instantly accessible.
Keep this in mind :
Before starting investing fix these 3 things
- Set aside 3 to 6 months expenses including EMIs as an emergency fund in liquid funds, bank FD or bank RD. Always keep it updated as your expenses increases. Consider Emergency fund as your expense, not your Investment.
- Buy online term insurance plan with maximum cover possible till you retire or you have dependents. Buy disability rider and accident benefit raider of equal sum assured along with the term plan or separately.
- Go for standalone (for you and spouse) or family floater health insurance plan as your base plan and buy a top up health plan apart from the one your employer provides. This arrangement will save your premium outgo.
Let’s go in detail about the Emergency Fund.
What s an Emergency fund?
Emergency fund is a kitty which is been kept aside to face any unforeseen event in the future. The events could be job loss, sudden decrease in income, sudden financial liability or temporary income stop due to temporary disability.
What is a purpose of an Emergency fund?
It mainly provides peace of mind to the individual. It gives assurity that the individual is well-prepared in short term to face any financial crisis. It also gives financial security by creating a safety net of funds for such expenses. If the individual has emergency fund he has not had to dig into his long term savings.
What should be the size of Emergency fund?
- Thumb rule is that one should have 12 months of his monthly expenses plus going on EMIs as his/her Emergency Fund.
- But if the investor has a stable job, good savings and controlled expenses he can set aside 6 months of his monthly expenses plus going on EMIs.
- If your spouse is working and you consider that job can cushion you in any shortfall of your income then 3 months of his monthly expenses plus going on EMIs. is sufficient as emergency fund.
For Example ;
Suppose Ajay is in IT firm earning handsome salary, and he can save up to 40 % of his salary then he can save 6 months of his monthly expenses as Emergency fund. In this case let us assume Ajay’s monthly expenses is 40000 and home EMI is 40000 then he should have 6 months expenses+home EMI as his emergency kitty i.e. 480000 Rs.
Suppose Radha and Jay both are in retail industry and draw approximately same amount as salary they can have 3 months expense as Emergency fund. If their monthly expenditure is 50000 then Rs 150000 will be sufficient as Emergency Fund..
Emergency Fund and Investment should not be mixed at any cost. Never consider the money kept aside as emergency fund as your investment. You should not map it with any of your goal. One should always update your Emergency kitty time to tie whenever your expenses increases. Emergency fund is an EXPENSE which you should incur and forget.
Where to park your Emergency fund?
Most important aspect of the emergency fund is it should be easily accessible at the time of emergency. Liquidity is the highest criteria. Second one could be Capital Protection. Whatever money we are keeping aside should be safe at all time. Third one is this money can earn reasonable return.
Following are the most preferred Financial Products used for Emergency Fund.
- Cash – Many people keep on hoarding cash at home for emergency. This is an age-old style of households. But it carries risk of theft, wear and tear and most importantly decreasing its value over time due to inflation. Keep cash only for your usual expenses not more than that.
- Bank saving account: This is another option for many investors. Here possibility of theft and wear and tear is taken care but what about returns on saved amount? If the inflation is considered as 6% your amount in bank saving amount is eroded as you can earn only 3/4 %.
- Bank Fixed Deposit : This s one of the recommended option for Emergency fund. You can park your amount here which provides liquidity, safety and as well as higher return as compared to bank saving account. Have an online FD so tat it can be terminated by sitting home in one click and you need not go to the Bank for the same. But FDs still not suitable for the highest bracket tax payers. Its post tax return drastically decreases for 30% Tax bracket investors.
- Recurring deposits: RDs in bank or post offices can be a recommended option for Emergency fund. If you don’t have sizable amount to do as FD you can start RD for one year and after its maturity convert it in FD. Again start RD for a year and convert it to FD. You can do it until you accumulate the targeted amount.
- Liquid Funds: This is the most suitable option for any investor preferably to the highest tax bracket investor. Liquid funds are simply debt mutual funds that invest your money in very short-term market instruments such as treasury bills, government securities and call money that hold the least amount of risk. The rate of return of liquid fund is always better than FD and RD. One can withdraw the amount instantly too.
- Credit card limit: Modern investor consider credit card limit as their Emergency Fund. If you have good credit history and uses credit card extensively bank offers huge credit limits. In case of emergency you can just swap the card and get it solved. But this is not a recommended option by me as if you are not able to pay the credit card amount you have to pay hefty interest on it and you can get trapped in new debt. It leads to erode your credit score drastically and future it will be difficult to get loans from the banks.
Personally I keep 6 months of my expenses as Emergency fund. I prefer combination of liquid funds, Fixed Deposits and Recurring deposits.