23 Mar 2014

What Is An Emergency Fund?

I have received a few emails asking me about an emergency fund. What is an emergency and why do we need it?
I have mentioned an emergency fund in two of my articles.
This article is dedicated to a friend who is saving a percentage of his salary every month in a sincere and dedicated manner.

What is an emergency fund?

It is a fund i.e. a savings account or a fixed deposit with six to eight months of living costs saved up. If you spend about Rs.30,000 per month then the emergency fund should have between Rs.1,80,000 to Rs.2,40,000.

Why do I need an emergency fund?
An emergency fund adds stability to your life. It is for those expenses that one cannot plan. It is for unforeseen circumstances like the following:
1. Your car stops working and requires repairs which cost a substantial amount.
2. Termites infest your house and you need to pay the exterminator and get new furniture.
3. You lose your job. While you are between jobs, you can use the emergency fund for your living expenses.
4. Your house gets flooded or suddenly needs repairs.
5. There is an occasion which calls for gift giving and sharing.

A fund kept aside for unforseen events lets you take things in stride. When things go wrong we are able to gain our balance easily.

How do I calculate the money to be kept in an emergency fund?
A humble request - please be honest with yourself about your monthly expenses. If you keep a budget and write down every little expense, you will find it easier to decide on the amount to be kept in the emergency fund. Simply multiply the highest expenditure amount in the last year by 6 or 8. E.g. if in the last year, you monthly expenses were between Rs.12,000 and Rs.30,000; the emergency fund should be between Rs.1,80,000 to Rs.2,40,000.
If you don't keep a budget, estimate expenses by including rent/mortgage; commuting expenses; groceries; utilities like telephone, mobile bills, electricity, water, etc. Also keep an amount for small indulgences like restaurant, movies  and for miscellaneous expenses.

What Can I Not Use The Emergency Fund For?
You can use an emergency fund for emergencies! Voila! I mentioned that this stash comes handy under unforeseen circumstances like loss of a job (heaven forbid !) or termite infestation. I know it is difficult but try not to use your emergency fund for a fancy cell phone, latest gadgets, buying new clothes when you have a full wardrobe, expensive restaurants and travel etc.

Do I Need Six Months or Eight Months of Living Expenses Stashed Away?
The answer to this really depends on you and your risk appetite. I would recommend eight months of living expenses stashed away since it provides relief and stability. However, if you have a higher risk appetite, have a stable and secure job, fund your PPF account to the maximum amount possible then it is okay to have six months of living expenses stashed away.

Emergency Fund or Personal Loan?
Some people ask as to why they need an emergency fund when they can take a loan during an emergency. One of the big things about having an emergency fund is that  we can minimize our dependence on loans. There are some debts in life which might be inevitable e.g. home loan. However, for small ups and downs in life we should dip into a pile of cash stashed away instead of taking a loan or swiping our credit cards.

Can I Use My Emergency Fund For Medical Expenses
Ideally we should all have medical insurance. A medical cover takes care of any unexpected medical care, hospitalization or treatment that we would need. If a good medical cover is in place, we won't have to dip into our emergency savings.

How Do I Build Up An Emergency Fund?
If you do not have the money lying in different accounts, try to save a percentage of your income every month. Make sure you keep a mental note of which account is your emergency fund. 

An emergency fund makes us peaceful and keeps us at ease. It should probably be renamed as the "peaceful fund" or "relaxed fund". Believe me when I say, it is well worth it!

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