Understanding Emergency Fund.

Emergency Fund is the most important component of personal finance.

Let us understand in detail what an emergency fund is.

An emergency fund is the amount of money that you keep aside safely so that in case of any emergency, you have some money backup to provide you some relief.

Let us understand with an example.

Suppose you have just started earning through a job or business or any other means. The first thing that you have to do (even before starting your investment journey) is to save as much money as possible, grow your savings and create an emergency fund.

Suppose your salary is 50,000/month. You pay rent of 10,000/month. Your food, grocery, electric bills, and other monthly important expenses are 15,000/month. So every month, out of your 50,000 salary, your important expenses are 25,000 rs, right?

You are left with the remaining 25,000/month. You have to save this money as much as you can. Do not eat out. Do not buy expensive clothes or branded phones or anything which is not important. Save as much money every month for the next 10-12 months.

You will then accumulate a good amount of money. 

This money is your Emergency Fund that you have to keep separately so that in the future, if you need money suddenly for any important reason, maybe you lose your job or you suffer a loss in business or you have a medical emergency in your family, this saving will be there for you to provide some relief. If you have created a good emergency fund, you will have good peace of mind knowing that no matter what happens in your job or business, you have a backup amount to support you in case you need it.

A question arises, how much money should it exactly be in my emergency fund?

In an emergency fund, you have to save at least 10-12 months of your monthly "important" expenses. This means, suppose your monthly important expenses are 25,000 rs. It only has to be your important monthly expenses like rent, grocery cost, petrol budget, etc. (Do not include your non-important expenses like eating outside or new clothes, etc). So suppose your important expenses are 25,000 every month. So, in your emergency fund, you should keep at least 10 months of important expenses money, which will be 25,000 multiplied by 10 months=2.5 lacs rupees.

You should keep at least 8 months of expense money and a maximum of 24 months of expenses money in this emergency fund.

In case you lose your job or you face any other financial issue, you will have this backup which should only be used to sustain your important monthly expenses for 8-10 months till the time you get a new job or your financial condition improves.

Another question that arises is where to keep this emergency fund.

After you have saved your emergency fund, you should put this money into Fixed deposits. Suppose you have saved 3 lacs of the emergency fund, you should open 3 fixed deposits and put 1 lac rupees each in each fixed deposit. Do not put your entire money in a single fixed deposit. If you put the entire emergency fund in 1 fixed deposit, in case you need 50,000 rs, you will have to break the entire 3 lac fixed deposit. If you have 3 fixed deposits of 1 lacs each and you need some money, you will only have to break one fixed deposit, and the remaining other fixed deposits will not be broken and continue earning interest.

Some people also suggest that emergency funds be put into liquid mutual funds. Liquid mutual funds are also good to keep your emergency fund but as in India, most people are not very aware of the stock market, so the suggestion is to keep the emergency fund in fixed deposits only. In case you have an idea of mutual funds, you can put your entire emergency fund in liquid mutual funds also.

An emergency fund should be kept in places where:

1) it is very easy to liquidate the money: suppose you have 3 lac rupees and you need the money suddenly as you lost your job. You can easily get that money from fixed deposit or liquid funds in 1-2 days because these are easy to liquidate. To liquidate means to get money out of these. Suppose you buy some gold out of this emergency fund, you will have to sell the gold at a cheaper price to get money. It might also take many days to take money out as gold, real estate, etc. are not easy liquid assets. So, always put your entire emergency fund in 2-3 fixed deposits or 2-3 liquid mutual funds. 

2) You should not think of earning good returns from this emergency fund. Emergency funds are to be created and kept so that you have money backup in case of an emergency. If you put this money in investment items like the stock market or real estate or gold or mutual funds, you might have a problem while taking the money out in case of emergency. So in the case of these 10-12 months of emergency fund money, it is good to simply put them in a fixed deposit or liquid mutual fund where your money is not lost to inflation as fixed deposits and liquid mutual funds provide almost the same interest as inflation rate and also are very simple to use and take money out in case of emergency.

(Liquid mutual funds are different from regular mutual funds, they are just like fixed deposits, so in liquid mutual funds also, your money is safe and easily available. Still, prefer fixed deposits for emergency funds).

In case you lose your job or get into a financial problem and you use your entire emergency fund or part of it, then after getting a job, you again have to fill this emergency fund first before starting your other investments. 

Only after you have created your emergency fund of at least 10-12 months, then start your investments in all other types.

Once you have created 8-12 months of an emergency fund, no need to save more money. Instead, after saving this emergency fund money, start investing salary/income money from next month in different investments like mutual funds, etc. Don't need to keep adding more money to this emergency fund once the 8-12 month fund is ready.  

Saving 8-12 months of the emergency fund is like buying your future safety and peace of mind. Do it in the first few months of starting your job.

Subhav Samarth

+91-9015661671.

gcsubhavsamarth@gmail.com