What is an emergency fund, and the mistake that most young investors make
In simple words, an emergency fund is a dedicated chunk of money that you set aside from your savings for meeting any emergencies. An emergency can be anything that you cannot predict, like a hospitalization, accident, job loss, legal problem, etc.
The biggest mistake that young investors make is that they don’t think through the risks in their financial life. The thought about creating an emergency fund doesn’t cross their mind. As a result, they invest all their savings into illiquid/ long lock-in investment avenues like gold, ELSS, PPF etc. And over time, when an emergency strikes, they are caught unprepared. They end up withdrawing money from their long-term investments and getting into personal loans and credit card debt. This not only derails their long-term investment plan but also saddles them neck-deep in debt.
An emergency fund is like a foundation of your financial building. You shock-proof your finances from the impact of emergencies. As a result, you don’t have to take unnecessary loans and get to continue with your investment plan with a minor pause.
How to calculate the amount of emergency fund
|Monthly Loan EMI||10,000|
|Total Monthly Outflow||50,000|
|Share in annual expenses||5,000|
|Total Monthly portion of Annual Cash Outflow||55,000|
|No. of months||6|
|Emergency Fund Required||3,30,000|
Please note that the amount of contingency fund varies from family to family. For example, suppose you are in a low-risk government job. In that case, even 3 months’ worth of expenses may be sufficient. Conversely, if you work in a private job, you can consider 6 or even 12 months, as there is a greater risk of job loss.
Which is the best avenue to invest the emergency fund money?
Never make the mistake of considering emergency fund money as a return generating asset. Instead, your primary goal should be that the money should be available in the minimum possible time and in a hassle-free way. In this context, you can consider investing the emergency fund money in the following avenues as below:
- Savings Bank account: The returns are lower than fixed deposits and mutual funds. However, the ease of availability of money is very high. Moreover, as per existing tax rules, interest on a savings bank account is tax-exempt up to INR 10,000.
- Fixed deposit: You can open it easily by visiting the bank branch or through net banking. You can also check out the sweep-in FD facility, wherein money above a certain threshold in your bank account automatically gets converted into a fixed deposit. This money then earns higher interest. Note that interest on a fixed deposit is taxable.
- Liquid funds: These are a low-risk and tax-efficient way of parking emergency fund money. They are low risk because they invest in highly liquid securities which mature in a very short time, so there is very little credit and duration risk. They are tax-efficient because the income from these funds gets taxed only on redemption of units and not every year.
An intelligent approach is to have some amount (equivalent to 1-2 months of expenses) in a savings bank account and the rest in fixed deposits/liquid mutual funds to earn slightly better return. Try to have the bank account and investments operate on “either or survivor” mode so that your spouse can operate the account in your absence. You should also try to keep some cash at a safe place in your home. This can help to make any urgent cash payments like initial deposit in hospital, ambulance, etc.
Some other tips relating to the emergency fund
- Focus also on having the right insurance apart from having an emergency fund. Having a contingency fund does not mean that you don’t need to buy insurances or vice versa. Both go hand in hand.
- It’s best to pause any existing monthly investments/SIPs in case of an emergency. Several mutual funds offer a pause facility for SIPs.
- If the emergency fund amount is large, you can split the total fund into multiple avenues (e.g. liquid schemes of two different fund houses). This can help in reducing the concentration risk. However, take care not to spread it in too many avenues.
- Maintain a certain discipline with your emergency fund money and don’t fall into the temptation of spending it on discretionary expenses. For example, that latest gadget in the market or a foreign vacation is not an emergency!
- NEVER EVER consider credit cards and personal loans as your emergency fund.
- Make sure to inform your spouse on how to access emergency fund money in your absence.