How to save for a "Rainy Day"- All about Emergency Fund.
Simple Finance weekly newsletter (Week 5)
You are earning well and living a life with all the creature comforts, but of late you are not enjoying your work, it is not giving you the satisfaction that you used to get earlier, you wish to take some time off and figure out your next move. You have a wife and a kid dependent on you, and then there are EMIs. Are you able to take time off for 3 months?
To face even severe unforeseen situations, you need a cushion to fall back upon, that is an Emergency Fund, and it is the first step in your Financial Independence journey.
What is an Emergency Fund?
Emergency Fund simply means putting some money away only to be used when you are faced with an unexpected expense. It is synonymous to our mothers’ stashing away few notes in rice dabba.
Most of us resort to using a Credit Card at the end of the month, though convenient but we end up spending our future income and may incur hefty interest on the spent amount. Having a backup fund also helps us from having to break a piggy bank named “Maldives vacation” or “Nimmo ki shaadi” which are indeed very serious financial goals.
What are the emergencies?
Illness of a family member and death of a primary bread winner are the most pressing emergency situations a family goes through. These two emergencies can be faced with a good Health insurance and a good term plan. (Term plan, emphasis supplied, not a Unit Linked Insurance plan ULIP or endowment plans. Keep Insurance and Investment separate.)
Cash (liquidity) is King
You must have heard about saving up 6 months’ worth of expenses in a savings account in case you lose your job or face pay cuts dues to situations like Pandemics or economic slowdown. Crucial thing to remember here is that the amount should easily be converted into liquid money, so keep it in cash, savings account (with a sweep in facility) or liquid mutual funds.
Liquid funds are a type of Debt Mutual Funds which invest in debt instruments having maturity of less than 91 days. Many Liquid funds offer an option of instant redemption of ₹ 50,000/- or 90% invested amount into your bank account. There is generally an exit load if withdrawal is within 7 days, and tax on gains as per your tax slab.
Indians tend to depend on Gold coins or jewellery for emergency. Price fluctuations, loss of tax paid and making charges may impact the corpus. Plus sentimental value and cumbersome process for selling to a jeweller or taking gold loan may come in the way of ease of liquidity.
Do not depend on a credit cards even if the spending limit is quite generous. Credit cards are a good way to boost your Credit score, but only when used wisely by paying the full amount and not just amount due, and keeping the credit utilisation below 30% of total limit on the card. This discipline most certainly can not be maintained in an emergency situation, and you will end up worsening your Credit score.
Its advisable to not depend for monetary help on relatives or friends. They indeed are an emotional support structure.
How to decide how much amount I will need?
For this arriving at a figure of monthly expenses is quite important. You may start with a spread sheet or use apps to track your expenses or even simple piece of paper. In this process you will learn to make a budget too.
To make a healthy budget 50:30:20 Rule can be followed where 50% of your monthly income will be spent towards all the necessary and unavoidable expenditures like Rent, Electricity, groceries, EMIs, broadband bills, fuel, medicines etc. Next 30% are discretionary expenditures where creature comfort expenses can be made like eating out, movies, fancy coffee, clothes, electronics etc.
Last 20% are the most crucial as this is the minimum that you need to keep aside and save up. Today the formula for Savings is not (Income minus Expenditure) but (Income minus Savings) should be your Expenditure.
This 20% should, in fact, be kept aside first. You can set a deadline by which you should have accumulated the emergency fund. If you have some savings which are not for a specific purpose, you can allot them here.
Once you are done with accumulating the stash/cushion of emergency fund by setting aside this 20%, then and only then you should move ahead with your equity investments which are for long term. Try to align your budget to 50:30:20 buckets first and then the 20% bucket needs to increase, firstly by reducing discretionary spending and later by doing away with EMIs. This is a step by step process. Please do not skip them.
Many people neglect creating emergency fund and end up having to sell some of their shares/Mutual funds to shore up the amount. This becomes worse when value of your investment has gone negative due to economic downturn as we have seen in Pandemic/lock down months.
So let’s assume that you earn ₹ 50,000/- as a monthly salary, then you should try to keep an emergency fund of ₹ 1,50,000/- which is six times your monthly expenses.
At times it will get tempting to spend this accumulated amount; you can use a separate bank account which has internet banking but no debit card. Do something but don’t spend without an emergency.
Seeing the recent turmoil, you can create a larger Emergency Fund. To face unforeseen situations of natural calamity, pandemic or even war, the backup fund can be increased to 12 months’ worth of living expenses.
This amount can be invested 70-80% in Liquid Fund/cash/savings account combo and rest in an Index fund. Please bear in mind that liquidating Index Fund will take around 2-3 working days, but it will help you earn a slightly higher(lower or negative) return than liquid fund, again there will be Short term or long term capital gains and exit loads. As far as possible, do not mix investment and emergency fund.
Long term Emergency Fund
There is one more Emergency Fund, in addition to the above, that very few people have talked about. This is the expenditure that comes once in a while when your car or AC breaks down; you break the screen of your Phone or spill coffee on your laptop, or attending a friend’s destination wedding. This fund will depend on your lifestyle.
This is one of the first steps that you should take before embarking on your investment journey. Emergency Fund along with life insurance and a health insurance are necessary to give you a sense of security and a solid start for your journey towards financial freedom.
“To be prepared is half the victory”- Miguel de Cervantes.