Two weeks back we discussed about a sure shot method of never running out of cash and promised to cover how much money you need for emergencies and how to create and maintain that emergency fund.
Keeping money ready for an emergency is important. Not only do not you have to worry about the money when you need it but also frees up money for long term investments.
A lot of people are afraid to invest their money for long term. They question “what if there is an emergency? I won’t be able to use my own money if it is tied up in long term investments.”
Unwillingness to take risk and long term commitment comes from the fear of not having money when it is needed. It is an understandable fear – it could be medical emergency, a job loss, disability or health issues that prevents you from earning, etc. However, there is a way to keep money aside for such emergencies and then free up your savings to invest for long term.
How much do you need in your emergency fund?
Our thumb rule says keep aside six months’ living expenses. Include everything in it – rent, EMI, school fees, utilities, premiums, memberships, etc. As per the cash flow system we created earlier, the emergency fund is simply your monthly transfer to your Spend-It account multiplied by six.
In case you are the sole earner of the house that has your spouse, kids and parents to support, it is better to have the emergency fund up to twelve months. However, it should not be less than six months in any case.
Why emergency fund when you can buy an insurance?
There are some events that you can look after through insurances, but there are some like job loss, that you need to prepare for. This is a fund that will be used in case of financial emergency only. You can’t even use it for down payment of the house.
Where do you keep this emergency fund?
Keeping this money in your savings accounts is a big NO. Firstly, the interest you earn in your savings account is extremely low and secondly, you need to put it in a place which is not easy to access but yet, liquid enough to be of use when you really need it.
The best place to keep this is Ultra-Short Debt Fund (also known as liquid plus). Make sure you have not traded portfolio quality for return. Reason for choosing this is that a shorter maturity debt fund category (like liquid category) yields very low return and is suitable for those who are looking to park their funds for few days to few weeks. On the other hand, any other category with a longer maturity definitely yields a better return but makes it riskier too.
Setting up your emergency fund in an FD is very inflexible and you might have to break the entire deposit when you only need a part of it. Moreover, FD rates are unfavorable at the moment.
What comes first? Emergency fund or wealth creating investments?
Creating emergency fund is always the first cushion you create before moving into long term investments and wealth creation.
Set yourself a monthly target for your emergency fund and keep crediting your emergency account each month. Once you get to your target, stop funding it, and you are ready to move to more long term investments like equity, longer maturity debt instruments, gold, real estate, alternate investments, etc.
Lastly, we all have realized the importance of emergency fund in the current situation of pandemic and past months of lock down. This emergency fund is simply the differentiator whether you slip into disaster or stay afloat.