Protect Your Financial Life With A Proper Emergency Fund – Here’s How
The pandemic has turned out to be a real black swan moment for everyone. No one could predict its arrival, and no one can say how long it will last. This is how emergencies arise. The least we can do is prepare better. In financial terms, you can do this by having a decent emergency fund.
This article explains how to set up an emergency fund, where to invest the money, and some best practices you can follow to make sure your money is useful when you need it most.
What is an emergency fund and the mistake most young investors make
Simply put, an emergency fund is a sum of money that you set aside from your savings to deal with any emergency. An emergency can be anything you can’t predict, like hospitalization, accident, job loss, legal issue, etc.
The biggest mistake young investors make is that they don’t think about the risks to their financial life. The idea of creating an emergency fund does not occur to them. As a result, they invest all their savings in illiquid / long investment avenues like gold, ELSS, PPF, etc. And over time, when an emergency strikes, they are caught off guard. They end up withdrawing money from their long-term investments and taking out personal loans and credit card debt. This not only derails their long-term investment plan, but also puts them in debt up to their necks.
An emergency fund is like a foundation for your financial building. You protect your finances from the impact of emergencies. As a result, you don’t have to take out unnecessary loans and continue your investment plan with a little break.
How to calculate the amount of the emergency fund
Typically, there is a need for an emergency fund of up to 6 months of IME loan expenses and commitments. Let us understand with the help of the following example.
Please note that the amount of the contingency fund varies from family to family. For example, suppose you are in a low-risk government position. In this case, even 3 months of spending can be enough. Conversely, if you work in the private sector, you can consider 6 or even 12 months, because the risk of job loss is greater.
What is the best avenue for investing the emergency fund money?
Never make the mistake of viewing emergency fund money as a yield-generating asset. Instead, your main goal should be to make the money available in the shortest possible time and without hassle. In this context, you can consider investing the emergency fund money in the following avenues like below:
# Savings account : The returns are lower than those of fixed deposits and mutual funds. However, the ease of availability of money is very high. In addition, in accordance with the tax rules in force, interest on a savings account is exempt from tax up to Rs 10,000.
# Fixed deposit: You can open it easily by going to the bank branch or via net banking. You can also check out the FD sweep feature, in which money over a certain threshold in your bank account is automatically converted to a fixed deposit. This money then earns higher interest. Note that interest on a fixed deposit is taxable.
# Liquid funds: This is a low-risk and tax-efficient way to park the emergency fund money. They are low risk because they invest in very liquid securities that mature within a very short timeframe, so there is very little credit and duration risk. They are fiscally advantageous because the income from these funds is only taxed at the time of redemption of units and not each year.
A smart approach is to have a certain amount (equivalent to 1-2 months of spending) in a savings bank account and the rest in fixed deposits / liquid mutual funds to achieve a slightly better return. Try to operate the bank account and investments in either or survivor mode so that your spouse can manage the account in your absence. You should also try to keep cash in a safe place in your home. It can help with urgent cash payments like initial hospital deposit, ambulance, etc.
Some other emergency fund tips
# Also focus on the right insurance in addition to having an emergency fund. Having a contingency fund doesn’t mean you don’t need to buy insurance policies or vice versa. The two go hand in hand.
# It is best to suspend all existing monthly investments / SIPs in case of emergency. Many mutual funds offer a break opportunity for SIPs.
# NEVER treat credit cards and personal loans as your emergency fund.
# Be sure to educate your spouse on how to access the emergency fund money while you are away.
The emergency fund has an important place in overall personal financial planning. A decent emergency fund helps you get through the tough times in your life with minimal impact on your financial well-being and investment planning. However, care should be taken not to spend this amount for discretionary purposes and ensure that it is easily accessible when needed.
(By Sujit Bangar, Founder, Taxbuddy.com)