Tuesday, March 19, 2013

What is an Emergency Fund & how to create..?

When you hear the word emergency all of sudden the ambulance alarm seems to go ON at the back of your ears. For us emergency means just one thing- a road accident. And on second thought, lot of us thinks why to keep an emergency fund, when we travel in a car. Traveling in car has low probability of an accident so I don’t need an emergency fund. Hospital charges will be met by mediclaim or by my rich papa so why to have an emergency fund?

Let me clarify – What is an Emergency Fund?

Emergency fund is a corpus which will be used to meet expenses related to unforeseen events of life. The aim to have emergency money is to avoid financial hassles which may deviate you from your savings for your long term goals. A typical example is that this money will not be utilized to replace your 5 year car (as the replacement of vehicle will be covered in your financial plan) but emergency fund can be used to make down payment in case your car gets stolen and you need replacement immediately.

When emergency fund is to be utilized?

1)      Medical emergencies if do not have cashless provision with the mediclaim provider.

2)      Financial emergencies like replacement of assets in case of sudden breakdown.

3)      Income emergencies like loss of job or slowdown in profession for cyclic reasons.

4)      Household emergencies like expenses required for education trip of child or a house repair which needs immediate attention.

5)       Your friend or family require support due to medical emergency. (not for buying new flat)

6)      Availing offers which can save money in future like making payment to reduce principal amount in case of interest rates raise in a flexible interest home loans.

Emergency fund can be used to help stabilizing your monthly budget and even making a few savings like saving on late payment penalties and allows you to negotiate price in certain cases as you have the money to purchase in bulk.

How much emergency fund is required?

This is a serious question and requires a bit of calculation. Different experts have suggested different ways ranging from 3 months expense to one year expense. The monthly expenses are very easy to calculate if you do budgeting. But this kitty of emergency fund is a dormant investment as the rate will be low as liquidity will be preferred. So if you go much beyond what is needed you are losing some profit you ought to earn. Hence deciding on the amount has to be accurate. I recommend that in modern world one thumb rule will not suffice clients with different backgrounds and earnings. Hence I would advise that you should maintain the emergency fund as per the following situations:

    In case you have a volatile job or businesses with no other source of income at least aim to maintain 12 months monthly expenses in your emergency account.
    In case you have a stable job but have a mortgage or an EMI running, which is over 40% of your salary, you should aim at keeping 9-12 months of monthly expenses and at least 6 months of EMIs in your emergency expenses.
    In case you have a fairly stable job or industry and a working spouse you should aim to keep around 6 months of monthly expenses in you emergency fund.
    In case you have a stable job and a working spouse with no or very miniscule loans, you may keep at least 3 months of monthly expenses in your emergency expense fund.
    You must also take into factors your personal situation. If you have a large family to support or someone in the family who is disease prone you need to increase the emergency fund accordingly.

How to create an Emergency Fund?

To set it straight, your credit card in NOT your emergency fund, so do not boost that you have credit limit of lakhs and hence emergency fund is not required. The cash or credit drawn on your card is a loan and a very costly loan. Also you the extent of time the emergency will take to settle is also uncertain. So you may end up yourself with banks chasing you for their money. You need to create a kitty of your own.
The steps to create an emergency fund are:

1)      Fix the amount that you wish to save to allocate to emergency fund. As discussed this will be decided on individual situation a person is into. So instead of asking a friend how much he has in his bank (he might also think that you are asking for a loan), it is better to put your own mind into calculations.

2)      Know your monthly expense as its helps both ways. You know how much you can save on monthly basis and also you can calculate what emergency expenses you require.

3)      Open a separate savings account with bank and designate this account as emergency fund. Bank does not recognize any account on the basis of emergencies. For them this is an individual account and for you it should be a non-personal account only to be used in case of emergencies. See that you have the ATM card facility with the account.

4)      Redirect your savings: now start redirecting your savings to this account. You may set an automatic transfer or do it on manually but you must maintain discipline in maintain your contribution till the desired corpus is created.

5)      When the corpus has been created ask bank to add the auto sweep facility. You may also take the help of your financial planner to help you invest in money market mutual funds.

6)      Situations will change in future so it is advisable to review the amount after every 2 years approximately.

Where to keep the Emergency Fund?

The emergency fund has to be in liquid and easily accessible. You may keep at least 10%-15% as cash at home in proper secured almirahs or vaults. Do not keep much as this will invite burglary. The rest can be put in Banks savings account with FD sweep facility and ATM cards. Around 40-50% can also be invested in money market mutual funds. But in case you invest in mutual funds you should be aware of the process to withdraw. Nowadays many funds like Reliance Money Manager Fund also provides ATMs for redemption, which is a very smart investment for Emergency Fund.
Watch out!!!

You will not drain the emergency fund for normal use. You should be clear when to resort to emergency fund. No NEEDS, WANTS or LUXURY will be bought funded from emergency fund. Needs are budgeted, wants and luxury are goal-planned. Also if you have used emergency fund or a part of it you should again recreate or replenish it.


Source : TFL

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