Photo: iStock
Photo: iStock

How to be prepared for a financial emergency

Here is how you should plan for a financial emergency that may occur as a result of a job loss, pay cut, medical emergency or divorce

Mumbai: Life can throw lemons anytime, and getting caught off guard is not a nice feeling. It is true for money as well. Hence, one of the key financial goals for any individual is to create an emergency fund.

A job loss, pay cut, medical emergency or divorce, all these can derail you financially. In such situations, an emergency fund can act as a cushion.

Here is how you should plan for it:

How much do you need?

An emergency fund depends on your expenses and income. The idea is to have enough money in case you don’t have your regular income or you can fund immediately without disturbing your current lifestyle and investments. The thumb rule is to have at least three to six months of your cash flow as emergency fund. For instance, say your monthly expense, including rent, grocery, travel expense and school fees of your children, comes to Rs50,000.

At any given point, you should have at least Rs1.5 lakh to Rs3 lakh as emergency fund with you.

“If there is a job loss or for some reason you are not able to go to work, the emergency fund will help you tide over the bad times. It will also not disturb your other financial goals," said Surya Bhatia, a New-Delhi based financial planner.

The emergency fund will help you continue with your other long-term investments. Many people dip into investments they have set aside for their child’s education or retirement in case of an emergency, which upsets their overall financial plan.

How to save and invest?

You can start by calculating how much you need and then keep aside money on a monthly basis. For instance, if it is Rs1.5 lakh, you can start by keeping aside Rs5,000Rs10,000 every month. Another point you must remember is that you should be able to access your emergency fund easily. Hence, it should be left in a product that you can liquidate quickly.

For your emergency fund, avoid putting money in products that have a lock-in period. You don’t want to be stuck with no money despite saving enough or paying a penalty for premature withdrawal. You also don’t want the money to lie around and earn no returns. When you keep aside money for emergency, make sure it earns you good returns.

Many people end up leaving money in their saving account for emergency purposes. You shouldn’t simply do this. A bank saving account will give you a 3.5% return annually, which is very low and is also taxable. You can either keep it in a bank fixed deposit or in liquid mutual funds.

When to use it?

Just because you saved money doesn’t mean you use it to fulfil your impulsive needs. An expensive dress or a holiday is not an emergency. Emergency is not a desire, but a need—something you can’t delay and is urgent.

You should be able to identify emergencies to avoid disturbing your financial life, despite saving money. In case you have used the money from the emergency fund kitty, start the process again and reload it. This way you will be able to tide through choppy waters.

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