How large should your Emergency Fund be? And where to put your emergency fund money? These are 2 main questions that you should answer with respect to your emergency fund.
Now I am sure that you know what an emergency fund is. But just for the sake of completeness, let me explain it in a few lines – your emergency fund is a pool of money that is earmarked specifically for unexpected, urgent, unplanned and real emergencies and situations that cannot be tackled using insurances or any other means.
An emergency might mean different things to different people. But in general, it’s like facing a temporary job loss; or uninsured medical emergencies; or unexpected travel for tackling family emergencies.
And in life, there are always few people we can’t say no to. So it’s possible that you may have to pitch in financially during such people’s emergencies too.
But do note that any planned discretionary purchase isn’t an emergency. You can’t call buying latest iPhone an emergency. 😉
I hope you get the drift as to what the emergency fund is meant for.
So let’s come back to the first question at hand then.
How large should Emergency Fund be?
A common thumb rule says to keep at least 6 month’s worth of essential living expenses as Emergency Fund. Note that this is a ‘common’ thumb rule. We will come to this aspect a bit later.
Now the question is what all comes in the essential living expenses?
Here are some pointers to what you can include:
- Regular monthly expenses like rent, food, other consumables, utility bills, children’s school and other fees, transportation costs, regular healthcare expenses, salaries for support staff (if any).
- It’s a good idea to also include home loan EMIs and even other EMIs if the loan tenure is long enough.
- Some of the non-monthly but important annual expenses like insurance, etc. can also be included.
- Leave out discretionary expenses on entertainment, eating out, vacations, etc.
So let’s say if your essential expenses are about Rs 75,000 per month, then the 6-month thumb rule tells that you need to keep Rs 4.5 lakh as Emergency Fund.
But let’s be reminded that this thumb rule is a general one. And different people need emergency funds of different sizes. It is quite possible that some individuals would require a bigger emergency fund. That is because their unique financial situation may require a bigger buffer to ensure complete financial security.
Any examples?
Yes.
Let’s say you work in a safe government job with almost no fear of job loss. So even a 3-month buffer may be fine. But if you work in a sector prone to layoffs, then you need a bigger cushion. Something like 6-9 months or even up to 12 month’s worth of expenses can be considered in such cases.
Let’s say you are the sole earning member of a 6-member family. And your friend is a part of a 4-member family where 3 members earn. So just imagine who will be in bigger trouble if both of you lose your job? Get the picture? So you being the sole-earner should have a bigger buffer to sleep peacefully at night.
So different people, different sizes of emergency funds.
One more trend I see is that at times people give justification of having a credit card as the reason for not keeping emergency reserves.
No doubt credit cards can be a quick solution and come handy in times of emergencies. But when the credit card’s interest-free period is over, the money has to be paid back eventually. That too in full to avoid exorbitant 40% plus card interest rates (To know more, read how is credit card interest calculated). In such a scenario, if the person has no buffer, then how will he suddenly find the money to clear off those card dues? Isn’t it?
So having some buffer is absolutely essential.
Now comes the next big question.
Where to park Emergency Fund?
In general, and this is common advice – having a combination of instruments like a savings account, fixed deposits, and liquid funds is sufficient for the installation of the emergency fund.
Here again, an individual’s unique situation and requirements may demand overweighing one vs the other.
Let’s carry forward the earlier example – essential expenses are about Rs 75,000 per month, then the 6-month thumb rule tells that you need to keep about Rs 5 lakh as Emergency Fund.
In general, there is a very small probability that in case of an emergency, the entire Rs 5 lakh will be required immediately. It’s not impossible but still a rare event.
So what can be done is to build a kind of tiered Emergency Fund structure.
How?
One can keep about 1-2 months of expenses in the savings account. This is sufficient 100% liquidity for most people. The remaining can be parked in fixed deposits or liquid funds (or ultra-short duration funds).
How to divide between the two?
It’s up to the individual. If you understand the risks with debt funds then you can park more in liquid (or ultra-short duration) funds as they provide better and tax-efficient returns than fixed deposits. But if one is a conservative saver and wants to take no risk at all, then simply keeping the rest of the money in bank FDs is good enough. But it also makes sense to put a major chunk of your FDs in the safe Indian banks for fixed deposits.
With regards to liquid funds, please note that even though some liquid funds offer instant redemption for a limited amount, the rest of the amount takes up to a day to get back to you if you need it.
Another alternative can be the Sweep-In Deposit facility that many banks offer. In this, if your saving account balance exceeds a given threshold limit (stipulated by you), the excess amount is automatically converted into a fixed deposit and it begins to earn the regular fixed deposit interest. In case you need the money back, the FD is liquidated automatically. But if FD rates are low, then even these sweep in accounts will generate low returns.
There is another useful option these days. The high-interest savings account.
These provide high-interest rate on savings account that is comparable to bank FD rates these days. At times, even more. That too with full liquidity of savings account. And since most people have more than one savings account and add to it the fact that these days many banks are offering high-interest savings account (that offer up to 7%), it makes for a genuine case for keeping more money in such a high-interest savings account. But it’s worth noting that mostly, the high-interest rate (like up to 7%) are only for the incremental amount above Rs 1 lakh or a similar threshold. For amounts below that, the regular interest rates of the savings account may be applicable. Some of these high rate savings accounts are feature-rich and offer services like ‘Invest the Change’ – which is, in a manner, an option to invest daily spare changes. Like you spent Rs 257. So it will round it to the next 100 (i.e. Rs 300) and the change of Rs 43 will be set aside and accumulated. Once the accumulated amount crosses a threshold (like Rs 500), it can be invested into a safe debt fund. So your emergency fund gets drip fed regularly and further increases in size. This may be a good feature for those who have a lot of regular expenses.
If that wasn’t enough, then there is the added benefit of the interest income from savings bank account being tax-free up to Rs 10,000 every financial year. So depending on how much interest your savings account gives, you can park different amounts to generate up to Rs 10,000 in tax-free returns every year.
Here is a ready reckoner for the amount that you need to generate that interest every year:
- At 3% interest, the amount to keep in the savings account is Rs 3.33 lac
- At 4% interest, the amount to keep in the savings account is Rs 2.50 lac
- At 5% interest, the amount to keep in the savings account is Rs 2.00 lac
- At 6% interest, the amount to keep in the savings account is Rs 1.67 lac
- At 7% interest, the amount to keep in the savings account is Rs 1.43 lac
Also, do read about the taxation of savings account interest.
And it’s worth mentioning the most of these new-age savings accounts allow for totally online and digital onboarding without a need to visit the bank branches. So that is something to consider too for those who are scared of visiting banks (due to reasons like this).
I suggest you also understand the taxation of fixed deposit interest before you decide anything and also make sure to compare it with the taxation of debt funds. Why I am saying this is because nowadays, debt funds are considered as good alternatives to bank FDs. So you should know what you are getting into and what your expectations should be with this useful financial instrument?
That was all about where to park your emergency funds.
But what to do if you do not have an emergency fund to even start with?
First, it’s time to wake up. Emergencies don’t check whether you have an emergency fund or not before striking you. So pull up your socks and acknowledge the need for them.
If you are among those who plan to dip into their long-term investments for unplanned expenses, then do remember that it will derail your savings for those financial goals from which you plan to withdraw from. And that is something that ideally shouldn’t be done.
Imagine having to withdraw Rs 10 lakh for an emergency from your 16-year old child’s higher education saving of Rs 15 lakh knowing very well that you will need the money in the next 1-2 years. Tough situation to be in. Isn’t it?
So what to do if you do not have an emergency fund?
First, is to figure out how much should you save up for emergencies?
Use the simple thumb rule discussed above to get going at first. And do not worry if the target figure seems too large and daunting at first. And take no stress if you cannot have the targeted amount in one go. Just do what you can. Start with one month and then take one additional month at a time. Build it gradually using monthly savings. Also, use your incentives or annual bonus to top it up occasionally. I would go to the extent of saying that you can even consider stopping your long-term investments temporarily to first put in place the emergency fund.
Note – Many people have this crazy urge for home loan prepayment. Can’t say it’s wrong. But if it means ignoring having an emergency fund, then it’s wrong. My advice to them is to stop being so aggressive about loan prepayment and instead shore up their emergency reserves first.
That’s about it.
An emergency fund may not seem like an important thing to have but it is. It’s a lot like an umbrella. You don’t need it during regular days but when it rains, having it helps a lot.