Most of us don’t have a crystal ball to peep into the future, so it’s imperative that we set aside four-six months’ expenses to tide over circumstances which may happen outside our plan or expectations and, it has to be done when things look normal. We have seen ants collect extra food for the rainy days when they may not be able to step out to fetch food.
Emergency funds are alternatively referred to as ‘contingency funds’ or ‘rainy day money’. It is that money which prevents our goal-based planning from getting derailed or defaulted on EMIs or not being able to honour my investment instalments, or not being able to meet my routine expenses. It works towards ensuring that you don’t need to borrow money from friends or parents or take a personal loan.
It could be a sudden loss of job or getting bed-ridden owing to some illness or accident or personal issues in the family and not being able to bring-in new clients, thereby restricting regular inflows.
Emergency funds should strictly be used for needs which are unplanned, for a disaster which struck suddenly; not for expense overruns or for budgeting gone haywire or for magnifying one’s targeted goal amount when the goal actually comes knocking.
The money that we use in our life has two key features, liquidity and returns. Liquidity means being able to use the money when need emerges and returns refers to the self-sufficient nature of one’s investments. It has to stay ahead of the two robbers of money (inflation and taxes) by a few notches. Regarding contingency funds, the priority is very clearly liquidity, returns can wait. That having said, one must aim for at least risk-free returns on this money.
Emergency funds should ideally be parked in liquid or ultra-short debt funds, so that one can get the money instantly or in one working day. Investing emergency funds in fixed deposits may compromise on returns (if broken prematurely) Also, it may be tax inefficient if and when the need does not emerge till three years. This is because long term capital gains on debt mutual funds (taxable at 20% after indexation) benefits do not apply to fixed deposits.
Emergency funds can either be built by investing lump sum funds in liquid or ultra-short MFs or by doing an SIP (when one-time funds are not available). These funds are the core of financial planning, they make the foundation stone. While planning for goals prepares one for the responsibilities, building an emergency fund helps to tide over any such situation which may not be in our normal sight of vision. It is as important as having a life cover for one’s dependents.
As we cross over to a brand-new year, it is high time we resolve to build one and unlike most other resolutions, let’s target to honour this one.
Stephen King has rightly said, “There’s no harm in hoping for the best as long as you are prepared for the worst".
The ultimate aim of a financial plan is to cut down on negative surprises. The plan works towards minimising our anxiety on money. Emergency funds help us on both these counts. We feel more adequate and comfortable in facing the unknown lying ahead.
(Deepali Sen is a certified financial planner, founder partner of Srujan Financial Advisers LLP and author of Why Greed Is Great)