Do’s & Don’ts of Personal Finance: Emergency Fund

What is an Emergency Fund?

The most essential personal finance element is an emergency fund. An emergency fund is a reserve of money that is easily accessible to combat financial stress. Emergency funds are handy during unplanned large expense or during a job loss. Prevent a tough situation from spiralling out of control with an emergency fund.

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Do you really need an emergency fund?

Let’s review this with an example. Arjun recently lost his job. While he searched for another one, he still had to pay rent and provide for himself. Even after cutting back on discretionary expenses, his monthly outflow was nearly Rs. 30,000. Arjun had new expenses that didn’t exist before. For instance, he listed on many recruiting platforms to find the right fit for his next job. After three months of relentless job hunting, Arjun found the perfect match!

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What would Arjun have done without an emergency fund? One option would be to rely on friends and family for help. But Arjun wouldn’t want to worry his retired parents. The other would be a personal loan. Personal loan quotes were 2%-3% higher now that he didn’t have a job. Without an emergency fund, one setback could cascade into a series of setbacks. An emergency fund blocks that cascading effect.

Building An Emergency Fund

The Do’s:

Review Your Needs

When was the last time that you estimated your emergency fund needs? Check every 6-12 months. Your emergency fund needs to keep up with your lifestyle and your needs. Bring it up to speed with your spending habits, financial goals, and cash flows. So, top it up as your expenses grow. Grow your emergency fund before you take any loans.

How much should your emergency fund have?

It should have at least 3-6 months’ worth of expenses. This includes EMI and discretionary expenses. Providing for discretionary expenses is crucial. When you’re financially stressed, knowing you can spend on yourself without guilt is comforting.

Your emergency fund requirements change according to your employment and cash flows. For a self-employed person, a larger emergency fund is recommended. Entrepreneurs need segregated emergency funds for business and personal needs.

Liquid Funds and Savings Account

The thumb rule is that your emergency fund is readily accessible. Options include savings bank accounts, short-term fixed deposits, sweep accounts, and debt mutual funds.

With debt mutual funds it’s best to stick to overnight, liquid, ultrashort, low duration, and money market funds. Their investment horizons range from 1 day to 1 year. Debt Mutual Funds process redemptions within 1 business day. They offer better market-linked returns than bank deposits. So, returns are not guaranteed and can fluctuate in value. They are also more tax-efficient.

 

The Don’ts:

Where to put emergency funds?

Higher returns often come with higher levels of risk. Therefore, your emergency fund investment may be more volatile. This defeats the purpose of an emergency fund. At a time when you need money the most, you don’t want to fret over capital protection. To select the right investment, focus on liquidity, predictability, and quality.

When to use the emergency fund?

This investment is meant for a rainy day. It’s not an alternative to a personal loan. So, don’t fund vacations, luxury watches, or gadgets with it. Instead, create a separate indulgence fund. The idea is to enjoy your money while maintaining financial security.

Emergency Fund vs Long-Term Savings

Saving for the long-term is a great financial habit to cultivate. Yet, it shouldn’t come at the cost of your financial security. Creating an emergency fund first can ensure continuity of investments. For example, a one-off expense won’t derail your saving plan.

In this market scenario, having an emergency fund is mandatory. To start with, you could generate liquidity by reviewing your long-term investments. Once you provide for contingencies, you should be ready for wealth creation!

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