Why You Must Have an Emergency Fund

Sudden job loss, car breakdown, unexpected bills, phone theft or a root canal: you could be hit by any of these emergencies and if you are not financially prepared, it may leave you stressed, both mentally and financially. This is the most important reason to have a contingency fund.

Financial planners insist that building a contingency fund is a must for every working individual. "Stacking away some ready-to-use cash is indispensable to a healthy financial plan as unexpected expenses keep cropping up," says Rohit Shah, founder and CEO, Getting You Rich. "A reserve of emergency cash will help you tide over unforeseen challenges without having to borrow."

A Separate Fund in Need

If you don't have money when an emergency crops up, what do you do? You may ask family or friends, but there's no surety that you will get the required amount on time. You can take a personal loan, which are easily available these days, but that means you add the burden of an EMI on your finances for the next 10-12 months.

"Sudden borrowing will not only disturb your budget but also impact your savings for other goals," says Renu Maheshwari, CEO and principal advisor, Finscholarz Wealth Managers. "An emergency corpus will save you from paying 20-25 per cent interest on a personal loan.

A separate fund earmarked for emergencies also ensures that you do not dip into your savings or investments meant for other goals. "If you withdraw from PPF (Public Provident Fund) in case of an emergency, you are putting your retirement in jeopardy. Or, say, you withdraw some of the mutual fund investments meant for your child's higher education. Since the timeline of the goal is non-negotiable, the required corpus will fall short and you may have to take an education loan to make up for it," says Shah.

What is The Right Amount

Experts say the emergency corpus should be equal to three to six months' of your expenses. The idea is to have enough money to cover your living expenses when regular income is disrupted or a surprise big-ticket expense arises.

"Add monthly bills, EMIs, insurance premium, rent and any other utilities and multiply it by three. That's the bare minimum you need to set aside for contingencies," says Shah.

The corpus can vary depending on the individual's lifestyle expenses, number of earners in the family, financial liabilities and health of self and other family members, among other things. "Families with elders should account for sudden medical expenses if they don't have an adequate health insurance cover. Family size is another key factor as more the number of dependents, more will be the contingencies to provide for," says Maheshwari.

When you have loans to repay, do not have adequate health insurance or you are the sole earner in your family, the corpus should be six to eight months' worth of expenses.

How to Build the Corpus

The cardinal rule of financial planning is to save at least 10 per cent of your income for emergencies. This practice should ideally begin with the first paycheque and continue until you have accrued enough to build a healthy rainy day fund. Building an emergency fund should be the top priority short-term goal.

Experts suggest that one can automate their savings toward the emergency corpus by starting a systematic investment plan (SIP) in a liquid fund or ultra-short-term debt fund. "An automatic transfer at the start of the month will ensure that the contribution is made before you start spending on other things," says Shah.

A liquid fund or short-term debt fund are the best avenues to park your emergency fund as they allow instant withdrawal, ensure capital protection and lock the money out of your sight so that it doesn't get spent. The focus should be to ensure liquidity and safety of the corpus and not chase returns.

Maheshwari points out that in these times of credit risk and defaults, the investor should spread the corpus across different instruments. "To ensure safety, it is important that the emergency corpus is spread across 2-3 savings avenues. The PMC bank fiasco and repeated cases of credit defaults by debt funds are a rude wake up call for investors to spread their money across different saving avenues," she says.

Remember that real estate and gold ornaments should not be seen as a fall-back option for emergencies. They are illiquid in nature and involve transaction costs that eat into the value of the asset. Also, you have to run pillar to post to carry out the transaction, which will add up to your stress in an already distressed situation.