Importance of an Emergency Fund
We plan our personal finances on the basis of future events that we are certain about. These could depend on the stage of life that we are at. A person who is well-settled professionally and is looking forward to getting married saves for their wedding, honeymoon, and other living expenses. Someone at an advanced stage of their career and a parent would plan for the education of their children and towards retirement.
However, how many of us plan for events such as our house catching fire and a major portion needing repair? Or thieves breaking in and stealing precious assets, including electric gadgets such as our laptops?
Of course, these are such unpleasant possibilities that we don’t even want to think about them. But we cannot discount the possibility of such events taking place. This is where an emergency fund works as a cushion and helps reduce the impact of such shocks.
If it is raining outside, probably we can’t stop it. But we can carry an umbrella so that we don’t get wet and catch a cold.
We all usually plan for the good times and forget to think of the bad. However, if we are wise, we should first make provisions for the difficult phases of life. Unplanned and unpleasant circumstances come without any notice. Being prepared for them is the most sensible thing we can do.
What is an emergency fund and why is it important?
An emergency fund (also known as a contingency fund) can help you to sail through a difficult financial phase such as job loss, a sudden medical crisis, or any kinds of event that impacts regular life and the economy such as war, social unrest, or a pandemic.
When you are starting to build a financial base, allocating money for an emergency fund is a wise decision to make.
A good emergency cover is like a safety net that will protect you during any unpleasant experiences in life.
An emergency fund is not the same as insurance
Many people confuse an emergency fund with insurance. We need to understand that both are different tools and fulfil different purposes. For example, health insurance will only take care of health emergencies. However, a contingency fund will be helpful in all spheres of life such as household or automobile repairs, unexpected purchases, or cash suddenly needed by a family member or oneself.
Insurance addresses the ‘known unknown’ while an emergency fund addresses the ‘unknown unknown’.
For example, when the Covid-19 pandemic hit the world, many people lost their jobs and many others faced salary cuts. In such a scenario, no insurance cover would have helped. In such a situation people may have exhausted their savings to survive or maintain a certain lifestyle. This is where emergency funds would have been the most helpful.
So what happens if we don’t maintain a contingency fund?
People who generally don’t maintain an emergency fund for meeting unknown risks usually end up exhausting all their hard-earned savings by breaking fixed deposit savings or other investments before maturity.
When we exhaust our savings, we also lose the interest we would get on them.
Personal loans and credit cards can come to our rescue in such times of crisis. However, we should be aware that these are expensive sources of quick money.
Also, when we take personal loans, we actually end up paying huge interest on the amount. In both situations, we end up losing. The best way to mitigate such losses is to create and maintain a contingency fund that will take care of your financial health at such times.
How much should I have in my emergency fund?
Deciding on the correct amount for one’s contingency fund is a difficult question. The answer will depend on your current income level, lifestyle, expenses, individuals dependent on you, debts, and other such factors.
Your contingency fund should be directly proportional to your lifestyle expenses. If you are unable to do this, lower your lifestyle expenses.
But there are some useful thumb rules that you can follow. A person who has just started earning and has minimal responsibilities can build a contingency fund that is equal to their income of at least three-six months.
However, if you are living with a family including children and dependent parents then an emergency fund equal to three months’ income probably will not suffice. In this case, you will need to make a provision for 12 months. Remember that crucial and unavoidable expenses such as school fees, clothing, house rent, and so on will form the bulk of your expenses.
How to manage your emergency fund effectively?
Emergencies knock at our door without any prior notice (that’s the nature of emergencies!). Therefore, your contingency fund must be easily accessible at a time of crisis. In an ideal scenario, your contingency fund should be completely secure and in liquid form.
Planning for making deposits in your emergency fund and maintaining it efficiently are two different things.
Liquidity has a key role to play in building a good contingency fund. Approximately 20% of our emergency funds should be maintained in the form of cash. The remaining amount can be kept in a savings bank account so that it can be withdrawn easily.
We should completely refrain from other conventional options such as Public Provident Fund (PPF), Recurring Deposit (RD), Fixed Deposit (FD), etc. This is because withdrawal before the due date for all these options can result in loss of interest.
Nowadays online payments are becoming more and more popular and acceptable. Hence having access to digital cash makes a lot of sense.
One last point related to your emergency fund is about security. We must be very careful to avoid investing our contingency fund money in high-risk options such as equity shares, small-cap, and mid-cap mutual funds.
The purpose of the emergency fund is lost in such cases, first, because it won’t be available to you easily. And second, and more importantly, because you can’t afford to lose your emergency fund to a bad phase of the market, as this can have a detrimental impact on your overall financial health.
Foresightedness is a forgotten virtue in the 21st century. We might be taking home a fat pay-cheque every month, but it is important to always be aware that the future is unpredictable.
An unpleasant storm can easily ruin the charm of life and instead make life very difficult. The smart thing to do is to plan for difficult financial times and invest in a solid emergency fund.
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Disclaimer: This article is for educational purposes only. It should not be considered financial or legal advice. Please consult a financial professional before making any significant financial decisions.