Emergency fund

One of the most important aspects of personal finance is to build an emergency fund. This is because, emergency fund allows financial security to cover unexpected but critical expenses.

Types of financial emergencies

First of all, let’s look at what kind of financial emergencies can occur and how an emergency fund helps to cover them.

• Loss of job or closure of business: Majority of Indian households are dependent on an active source of income. Therefore, an unexpected  stoppage of this source would create a financial chaos. Having an emergency fund to cover the basic expenses(rent/maintenance, utility bills, groceries, tuition fees, medicines, EMIs etc.) creates a financial cushion, until another source of income is found. 
• Medical emergency: In recent years, there has been a sharp rise in the costs associated with hospitalization, lab tests, medicines, treatments etc. As a result, any illness or accident of a family member can exhaust a lot of savings of a household.  
• Death of an earning member: In case of such unfortunate event, the dependents of an earning member would be in a deep financial crisis after all existing saving is exhausted.    
• Natural or man-made emergencies: Natural calamities like flood, fire or earthquake can cause damage to one’s residence and household items. Similarly, burglary, theft or riot can also cause financial damage to a family’s property. 
• Unplanned maintenance/repair work: A seepage or electrical malfunction requires immediate attention resulting in high maintenance costs. Its better to be ready than sorry. 

Apart from these, there can be financial emergencies related to an unplanned travel, divorce settlement(still rare in India) etc.  

Preparing for financial emergencies

It’s possible and easy to be financially secure against specific kind of emergencies. 

• Buying a health insurance for the earning member and all dependents would safeguard against any medical emergency. Nowadays, there are policies that also cover critical illness like cancer.  Any premium paid for health insurance provides income tax benefits. It’s also important to maintain a healthy lifestyle(balanced diet, exercise, regular health check-ups) to avoid any lifestyle related diseases. 
• Life insurance(or term insurance) policies provides coverage to designated beneficiary in case of untimely demise of the policy holder. Thus, even if an earning member is gone, the dependent family would get a lump-sum or recurring payments to manage their finances. Premium paid on these policies also provides income tax benefits. 
• Nowadays, home insurance can settle majority of these costs when property is damaged due to natural or man-made causes.
• Vehicle insurance(mandatory by law) covers costs associated with damage to vehicles or 3rd-party. 
• Apart from different kind of insurance, a separate fund is required to cover basic expenses in case of job loss or business closure. Most financial advisors and blogs recommend having a fund equivalent to 3-6 months of expenses. This is the actual emergency fund that one needs to build. 

Building an emergency fund

An emergency fund should allow easy access and liquidation into cash. In addition, it should ensures that one doesn’t need to take personal loan or pay high credit card charges(if not paid in full). The fund should be enough to cover at least 3-6 months of household expenses. Once this is achieved, the target should be increased to 1/2/5 years of expenses.

In my opinion, keeping money as cash or in savings bank should be avoided due to minimal returns. Instead, instruments like fixed or recurring deposits provide 6-7% returns and can be liquidated easily.  

If one has discipline in credit card usage, then credit cards can easily cover some emergency requirements. However, one should not exhaust the credit limit and also pay the dues in full. 

Liquid funds(a type of debt mutual funds) is another investment option to build emergency fund.  

We should also keep the investment(s) and insurance(s) separate. Hence, buying ULIPs is not recommended by majority of financial advisors. 

Our emergency fund

In our pursue of FIRE, we are limiting our expenses as much as possible.  On an average, our monthly expenses are Rs. 50,000 and hence a fund of Rs. 3 lakhs will cover our expenses for 6 months.

We have created FDs/RDs in our salary accounts to cover 1 year of basic expenses. Apart from these, we also have long term FDs in separate bank accounts for further needs.

We also have credit cards with high credit limit for any immediate major expense. The payment of credit card dues would be done by breaking the FDs/RDs.

We have a good medical cover and a basic life cover from our employers. However, we will also buy personal health and life insurance soon.  

In worst case scenario, we can also reach out to family for help.    

What are your thoughts and suggestions for building an emergency fund? Please share in the comments section.