Do you have an emergency fund?

To the above question, the most answers I receive are a big yes. However, I realise that most people do not understand the concept of emergency funds in a real sense of the word. Many people equate emergency funds to a common savings bank account or a salary account. Sadly, they operate the same account for cash withdrawals to meet routine expenses. The bare minimum amount keeps on fluctuating in the so called emergency fund kitty and is refurnished for a brief period when salary is credited in the first week of the month. Let us discuss the real purpose of these funds, how much is adequate and where to park them.

Significance of emergency funds: These are required in the event of unfortunate situations that life throws at us. It could be a medical crisis or a loss of job or something else. After the Global Liquidity Crisis of 2008, many employees in the IT and Finance industry were handed the pink slips. Many people take job security for granted and hence are not prepared for these kinds of situations. During a medical emergency in a family, liquid money is required even if one has bought a mediclaim policy and opted for a cashless settlement. This would be to clear ambulance charges, day-to-day medical expenses, initial diagnosis, etc. Certain hospitals even ask for a refundable deposit before settling the dues with the insurance company. During such difficult times, people usually end up breaking their bank fixed deposits or redeeming mutual funds or making huge payments by credit cards. An emergency fund helps to sail through critical times. It should thus be given precedence over your regular investments being made in equity, gold or debt instruments.

How much is sufficient: An emergency fund should cover house hold expenses of six months. This includes the groceries, utility bills, entertainment, children’s school fees, EMI,etc. It should also take into account medical emergencies as mentioned earlier. For any individual, the probability of using an emergency fund during a health crisis is higher in a lifetime than for any other situation. It could be normally about Rs.2-3 lakhs. However, it may vary from family to family. For instance, there are families where many members have chronic health problems or some have 2-3 senior citizens or some do not have adequate medical cover, sometimes none at all. Such cases warrant a higher emergency fund. The fund amount can be gradually reduced once sufficient medical cover is purchased.

Where to park emergency funds: The prime reason of maintaining an emergency fund is that an individual has access to instant cash during an unfortunate event. Liquidity and safety are the key things here rather than attractive investment returns. So, the best option to park emergency funds is a savings bank account. Another option is flexible fixed deposits with auto renewal option and linked to a bank savings account. One can break the FD during emergencies and withdraw money instantly using an ATM card. You can also split the money and put 50 per cent in a savings bank account and the rest in a flexi-FD.

Although the returns from short term liquid mutual funds will be comparatively higher, they are a riskier option. Redeeming them will take 24 hours at least (even more if it is a public holiday the next day) and the whole purpose of maintaining an emergency fund will not be served.

Before you park emergency funds, make a list of the nearest bank branches from your home and/or place of work and enquire about the ATM withdrawal limit. Distribute the emergency fund amount in at least 2-3 branches so that you can withdraw maximum amount through your ATM cards on a single days. Use the emergency fund amount for urgent crisis-like situations only. It should not be touched for your day-to-day spending affairs. More importantly, replenish you contingency fund once the emergency has passed.