With job loss, rising costs and unexpected expenses, especially those related to health, becoming a reality, more and more people are suddenly finding the need to have an additional source of funds to meet expenses and obligations.
If you are among the financially prudent who has an emergency corpus, then you have one less thing to worry about. But you must also know how to make the most of the emergency fund so that it continues to give you the security that you want.
Define the use
Like everything to do with personal finance, the decisions related to the emergency fund, including what constitutes an emergency, depends upon your individual situation. Clearly define what you will use it for so that you can better deal with the temptation to dip into that pot of money whenever you fall short of money.
Shilpa Wagh, a Sebi-registered investment adviser and chief executive officer of Wagh Financials, said, “There are some situations that arise on account of personal factors such as a job loss which warrants using the emergency fund; then there are unplanned, large expenses that have to be met for which, again, you draw from it."
While the first type of emergency can be provided for by creating an emergency fund that is adequate to meet essential expenses, including meeting repayment obligations and paying insurance premiums, for a certain number of months, the second category cannot be planned finely. “Apart from job loss, expenses related to health are the ones that often drain an emergency fund," she said. If it is a job loss or lower household income you are dealing with, then you won’t really know when things will get back to a normal. You need to be doubly careful about what you spend the corpus on so that you can make it last. You may run out of funds soon if you don’t cut back and avoid spending on discretionary expenses.
Naveen Julian Rego, registered investment adviser and certified financial planner, believes the emergency fund is the shock absorber in a person’s financial life that will shield it from emergencies and unexpected expenses. “It is not always possible to plan every expense. Sometimes there is an expense that may not fall under the emergency category but I would feel that it warrants drawing from the emergency fund because the alternative would be debt or raiding investments earmarked for long-term goals," he said.
Safety and liquidity
“Safety and liquidity come first and returns a distant third," said Rego, talking about how the money in an emergency fund should be invested. He believes in keeping the products simple and convenient to navigate, especially for conservative investors.
Savings bank accounts hold a portion of the emergency funds for all investors for the safety and ease of withdrawal. Rego points out to the tax exemption of up to ₹10,000 on interest earned on savings accounts as one of the points to consider when deciding to park a portion of the emergency fund in them. The other product that provides comparable safety and liquidity is a liquid fund.
While returns are not a priority while investing for an emergency fund, Wagh does consider the option of investing some portion of the fund into slightly longer-term products too, particularly when the sum of money earmarked for the fund is large. “Around 15% will be held in the savings bank account and this is the money that is immediately accessible. Another 35% should be held in short-term fixed deposits (FDs) that are linked to the savings account so that you can access them quickly in case of an emergency, and the remaining 50% is held in arbitrage funds for the benefit of lower tax applicable on equity funds," she said. “Ladder the FDs so that you hold deposits of different maturities and in the event of a need you have access to funds, without penalty," she added.
Given that the emergency fund is not invested for earning good returns, the inclination will be to hold the bare minimum required. Both Rego and Wagh recommend having funds worth a minimum of six months of expenses. But set aside more if your finances allow it so that you can deal better with loss of income or a large expense.
Having adequate funds helps keep debt at bay, particularly in a situation where there is stress on income. “If the emergency fund is drained due to a large expense, then using low-cost debt can be considered to make up for any shortfall, provided the income can bear repayment obligations," said Wagh. “Taking debt and creating liabilities will worsen a situation if the emergency is on account of income being affected," she added.
Wagh stresses on the need to be practical while planning an emergency fund and its use. “We may want the fund to be used only to meet essential expenses but it is not always possible to cut back on lifestyle-related expenses. And if this is not provided for, you may find the fund running out faster than you expect it to," she said.
Go beyond the recommended six months of expenses and be realistic in estimating the expenses you may have to meet beyond the mandatory ones. Build a separate medical fund that reflects the health needs of the family so that you do not fall short if the need arises.
Assess the adequacy of the emergency fund as part of the annual financial plan review and do it any time there is an event that has an impact on income and expenses. The emergency fund is not a single-use product. Investors should also be disciplined about replenishing it on a priority, whenever it’s used. Also, it is a financial goal that you have to fund all through your life. There will always be risks to income and the emergency fund is an essential safeguard against it.
Both Wagh and Rego believe that if the impact of not having an emergency fund is understood well, then people are likely to be disciplined about building, drawing on and replenishing it.