The thought of not getting your salary for even a month is scary for most salaried people. There are bills to be settled, rents and instalments to be paid apart from the expenses for everyday needs. Now, imagine, not getting your salary for two months or more. The reasons: a job loss, a sudden medical condition, an accident, or delayed salary due to a cash crunch in your company. The possibilities are unending.
It is in such situations that an emergency or contingency fund comes handy.
What is contingency
It is important to not confuse contingencies with things and event you can plan for.
For instance, if you have old parents and know they have a certain health history, you could prepare yourself for a sudden medical crisis.
Occasional needs for excess cash for reasons such as gifting or a sudden break down of an electric appliance, relocating to a new city, or such expenses, do not fall in the ambit of contingency.
Graphic by Shyamal Banerjee/Mint
Why is it necessary
To have a fund to meet such emergencies is a must. And the reasons are obvious.
You may need to use up your savings. As a result, your goals may get derailed. Liquidating some of the assets may also come at a cost.
Moreover, you may end up with a debt burden. A personal loan will come at an interest rate of 18-22%. Even temporary loans from relatives may cost you much in the long run.
Says Ranjit Dani, Nagpur-based financial planner and partner, Think Consultants, a financial planning firm, “The idea of having an emergency fund in place is to have a risk-free back-up plan if something goes wrong.”
How much is enough
Your emergency fund should be big enough to meet all your monthly expenses, regular contributions that you make towards any investments and instalments for any loans that you are repaying. It is important to determine this amount as accurately as you can.
Says Suresh Sadagopan, principal planner, Ladder7 Financial Advisors, “When we ask clients for their monthly expenses, they throw a rough estimate, but often the actual expenses are a lot more than the figure they quote.”
The best way to come up with a reasonable figure would be to track and note down your expenses for a few months and then arrive at it. Sadagopan adds, “Usually it is advisable to have enough funds to cover all your monthly expenses for at least three months, but if your income is variable or seasonal, then we recommend our clients to set aside enough to meet about six months of expenses.”
Where should you keep
The most important thing to bear in mind while stashing away your emergency funds is the need for quick and easy access. Says Dani: “You should choose avenues that allow you easy convertibility in terms of both time and money, which means you should be able to convert it into cash without a huge penalty and there should be no risk attached to it. So, you should be able to withdraw it when you need it with the least possible loss of value.”
But that does not mean you hoard it at home and earn no interest in it. Even in a savings account, you will earn merely 3.5% per annum.
This kitty is best stashed away in sweep-in accounts or flexi deposits, which let the excess in your account earn a fixed deposit rate. Short-term debt funds and liquid funds are also good options. These can be converted into cash within 48-72 hours.
If you don’t have it
If an emergency strikes before you are able to build a corpus or have exhausted it, here are some options.
But before you choose an avenue, you need to evaluate all your options and the opportunity costs involved. There are no set rules and it differs from case to case.
You could liquidate your assets, take a loan against them or go for a personal loan. Says Dani: “If the financial crunch is short term and you need money only as a stop-gap arrangement, then it makes sense to go for a loan against an asset. However, if it is long term and repaying the loan is going to be tough, then it is better to liquidate the asset even if it comes at the cost of eroding its value, lest the repayment pushes you into debt.”
If you are encashing some of your investments, begin by liquidating assets where the value erosion and the penalty is minimum. For instance, today most banks do not charge heavy penalty for breaking your fixed deposit—you only lose the interest for the period your didn’t hold on. However, if you sell your shares when the markets are low, you will incur losses. Similarly, you may end up selling land at less value for quick money.
Says Dani: “People often confuse ability with possibility. For instance, withdrawing the money you have invested in stocks and equity is possible at any time, but it may not necessarily be advisable at all times. So just because an investment is liquid doesn’t mean you should liquidate it.”
Similarly, you could also go in for a loan against your insurance policies, gold, fixed deposit or even your shares and securities. “These loans are usually processed quickly,” says Sadagopan.
The last resort should be a personal loan. “The interest you have to bear on this is usually more, although it is processed quickly. So, this should ideally be your last option.”
You could also work out informal arrangements with your family or trusted friends. Adds Sadagopan, “I have seen some family pools work really well.”
However, the best option is of course to build an emergency corpus as soon as you can.