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Why building an emergency fund is a must in today's times

Why building an emergency fund is a must in today's times

Build a fund that can be used in times of emergencies such as job loss and unexpected medical situations. While building an emergency fund, the two important things to be kept in mind are the amount required and the investment options.

You have lost your job. A new one is yet to come by. But you still have to pay your utility bills, children's school fees and car and home loan equated monthly instalments or EMIs.

Such a situation may not be very common, but is not improbable either, given that most of us work in private companies, which have a strict hire-and-fire policy.

If a job loss is 'unlikely', how about a medical emergency befalling you or your family member, requiring you to arrange an amount that is much more than your savings?

How can you cope with a situation where your regular income stops or you incur sudden heavy expenses?

For times like these, you should build an emergency or a contingency fund, which is nothing but savings parked in liquid options to be used during crises such as job loss and medical situations. Liquidity, or the ability to turn into cash, differentiates an emergency fund from other investments.

While building an emergency fund, the two important things to be kept in mind are the amount required and the investment options. These, in turn, depend on factors such as:

Stability of income:
If you are salaried, the size of your fund will be smaller than if you own a business, especially a start-up.

Outstanding loan/EMIs:
The size of the emergency fund depends on your expenses, which include loan repayments. Thus, if you have outstanding loans on which you pay EMIs, you need a bigger fund.

Number of dependents:
If your spouse is not working and you have dependent parents and children, the size of the fund has to be bigger.

Size of liquid assets:
Many people invest a majority of their savings in non-liquid assets such as real estate, Employee Provident Fund, Public Provident Fund and longterm fixed deposits.

"Such investors may need a bigger contingency fund compared to others with exposure to liquid assets such as bond funds," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Medical insurance:
One of the objectives of building an emergency fund is to take care of unexpected medical expenses. Buying health insurance with cashless facility provides protection on this front. If you do not have medical insurance, you may have to set aside a bigger amount for medical exigencies.

It varies according to your expenses, stability of income, etc. It can be three-six months' expenses for the salaried and up to 12 months' expenses for the self-employed. For individuals in a new business, it could be up to 24 months' expenses.

While most people would consider parking money in savings accounts due to their liquid nature, experts say it's not a good idea.

"Such contingencies happen once or twice in years and keeping money equivalent to three-six months' expenses in savings accounts is not advisable," says Vivek Karwa, a certified financial planner.

Up to a month's expense can be kept in savings accounts, says Dhawan. The rest can be invested in liquid, liquid-plus funds, other short-term debt funds and savings-cum-fixed deposit accounts that have a two-way sweep option.

Liquid funds are short-term schemes from where money can be withdrawn anytime without any exit load. Since they invest in fixed income instruments such as certificates of deposit, commercial papers, treasury bills, government securities and other debt papers with maturity of up to 91 days, they are considered safe.

Liquid funds also give better returns than savings accounts. While most banks offer 4 per cent on savings accounts, liquid funds have given 7-9 per cent annual returns in the last one year.

Other short-term debt funds such as liquid-plus funds invest in longer-term debt securities to generate higher return than liquid funds. Investment can be redeemed with exit load (if redeemed within a specified period) in three-four days.

Many banks offer term deposits linked to savings accounts which pay interest equal to term deposits and also offer anytime withdrawal. However, if the deposit is withdrawn prematurely, the interest is paid at a lower rate (usually by one percentage point).

Published on: Oct 30, 2012, 12:00 AM IST
Posted by: Gaytri Madhura, Oct 30, 2012, 12:00 AM IST