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How important is it to create an emergency fund?

05 Jan 2023

What do we understand by an emergency fund and when do we need to create an emergency fund? There are different approaches to this question but there is near consensus over the fact that an emergency fund is a must for everybody to have. How large should an emergency fund be? That largely depends on what is the purpose of your emergency fund. Typically, an emergency fund should be around 4-5 months of your monthly expenses which should be kept in very liquid forms like savings accounts, money market mutual funds etc. The idea is to keep these funds as close to cash as possible. The idea of keeping an emergency fund is that you do not have to disrupt your financial plan or indulge in distress sale of investments to raise money at short notice. The reason could be anything like loss of job, downslide in business, medical emergency etc.

How much of emergency fund you need to create?
As stated above, the benchmark is to cover about 4-5 months of regular expenses so that in the event of an emergency you can fall back upon the fund. The idea of an emergency fund is that not having an emergency fund can be quite prohibitive. Remember, this emergency fund is distinct from your insurance need and is available just as a small provision to fall back upon for a short period of time. Having an emergency fund gives you that mental peace of mind and that is its biggest contribution. Ensure to park your emergency fund in highly liquid assets like savings accounts, money market funds etc.
There are 5 key situations when you can actually fall back upon your emergency fund..

1.  When you lose income due to job loss
This is quite common in the private sector. Your company may shut down or the company may simply find you redundant. Quite often you have a notice period of 3 months and after that if you still have not got a job then your emergency fund will kick in. Getting a lateral job when you are at a more senior level is quite difficult and therefore you may have to prepare yourself for a longer tenure of job search.

2.  When your business is going through difficult cycles
When you are running your own business, you are already going through a liquidity crunch due to payment cycles being erratic. Things can actually get worse if your business is going through negative cycles. If you are into business you will realize that tough times come in hordes and it is never easy to keep your family immune from these developments. The very best that you can do is to create an emergency fund so that the transition for the family is as smooth as possible.

3.  Unexpected expenses crop up
This is a big challenge that many of us are not prepared for. The fact is they can make a mess of your monthly budget. For example, your car meets with an accident and the insurer will only meet a part of the expenses. You shell out a princely sum from your own pocket. Alternatively, the incessant rains have made a mess of your home and it requires urgent repairs. These are the kind of expenses you can neither avoid nor postpone. Nowadays you may even have to fall back upon your emergency fund to pay the upfront deposits for your child’s school. These are unexpected outlays that can make a mess of your regular household budget. To add to all these, you could have sudden travel expenses. Attending a marriage function with four people and flying up and down can cost quite a bit. These are occasions when your monthly budget can go for a toss. You can fall back upon your emergency fund but ensure that the fund is immediately replenished.

4.  There is a sudden medical emergency of a loved one
Who can really predict medical emergencies? Today, most of us have medical cover but there are many prolonged illnesses that are not exactly covered by the medical policies. Medical expenses are not only of the hospitalization variety but also entail confinement at home. If you add up the expenses of nursing, attendants, medicines, equipment etc it can add up to quite a bit. These are medical emergencies wherein you cannot avoid the expenses. Just ensure that once you dip into your emergency fund you also make it a point to replenish the same.

5.  You don’t want to disrupt your financial plan
The key reason for having an emergency fund is actually quite proactive. The biggest challenge in your personal financial plan is to ensure that the long term plan does not get disrupted mid-way due to financial exigencies. In fact, an emergency fund should be part of your broader financial plan so that the plan actually becomes more sustainable in the long run. It also becomes largely fool-proof.

Emergency fund is a must but ensure that the fund is not too large. After all, you need to invest the funds in liquid funds where the returns are likely o be very low. Striking this balance is at the crux of the matter!

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