Why setting up an Emergency fund is important before investing?
Emergency fund is one of the critical components of financial planning. Investing for long term without an emergency fund may not be a prudent approach as an emergency situation might wash your entire investments without reaping the power of compounding.
What is an emergency fund and when to use it?
An emergency fund is an umbrella that helps you to stay dry on a rainy day. It is a fund that helps you to cover your unforeseen expenses without getting into debt. For example, in the event of unexpected job loss this fund will help your finances until you get your next job or if there is a sudden medical emergency the fund will help you manage your hospital expenses above and beyond your medical insurance limit. You have to remember that emergency is to be used for an unexpected emergency expense and not for any lifestyle expense like a sudden vacation plan to Dubai.
How much emergency fund?
In order to arrive at the value of emergency fund, first you should calculate the monthly expenses including the EMIs. You may exclude the ongoing investments.
The formula would be something like this:
Monthly Emergency Fund = Monthly Expense + EMIs (if any) + Ongoing investments (optional)
For a single income family with no elderly dependents an emergency fund to last for 6 months is recommended.
For a single income family with elderly dependents, the emergency corpus should be able to last 9 – 12 months.
For double income families the emergency fund corpus should be equal to around 3-6 months’ expenses.
These are indicative amounts and will change on case to case basis but can be used as guidance. The emergency fund should be assessed every year during your yearly financial planning review and any deficit due to inflation should be compensated by adding the amount in the fund.
How to build the initial corpus?
Finding out the required corpus for emergency fund can be overwhelming and sometimes be a deterrent as the amount might seem big. However, the emergency fund can be accumulated over time with few simple strategies.
If you have existing investments which are not marked for any specific goal, you may allot them for emergency fund.
You may accumulate the remaining amount required for the emergency corpus by regular savings over the year or year and half, without disturbing the ongoing investments a lot. You may delay the big ticket expenses like foreign vacation, purchase of a new gadget till you have accumulated an adequate emergency corpus.
Where to park the emergency fund?
An emergency fund should be liquid, easily accessible during emergency, low volatility with no downside risk and at the same time away from you so that you don’t touch it unless there is an emergency. Here are few avenues where you can park your emergency fund.
- Liquid funds are one of the best places to put a part of your emergency fund. You may keep around 50% of your corpus in these funds. As the name says, these funds are very liquid and you may get the amount if needed immediately or maximum within one day. These funds give around 7%-8% returns, which is better than savings account. Check out some of the best Liquids funds here.
- Remaining 50% corpus can be invested in ultra short term debt fund which have low volatility and returns are better than a Fixed Deposit. These schemes might have exit load, hence choose them carefully.
Common mistakes to avoid
- Do not invest the emergency fund: Do not treat the emergency fund as an investment and never park it in Equity Mutual funds.
- Credit card as emergency fund: Using Credit card as emergency fund is not a prudent decision, as if you are not able to pay the bill within the due date you will end up paying very high interest.
- Investment is not emergency fund: Never treat your existing investments which are done for a specific goal as an emergency fund, even if you intend to replace it some time later. If you use your investment for an emergency then it will delay the time period to reach your goal as you lose the impact of compounding.
To conclude, having an emergency fund will not only help you to avoid mental stress during any financial emergency situation but also will prevent you from getting into debt.
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