What is an Emergency Fund
When you create a financial plan for yourself, you try to create a plan which will suffice for all scenarios which means how so ever external circumstances, you are able to respond to situations and are not forced into any sort of financial crisis, For any good financial plan emergency funds is and essential and a foremost component.
Emergency fund is designed to help you any unplanned expense or your cash flows goes bad,this is your security against a rainy day, when a surprise rain comes ( like sudden loss of job,natural disaster etc)
An emergency fund by nature should be liquid and accessible at short notice.
Where all can you use an emergency fund
An emergency fund by definition is for some unexpected circumstances in your financial life cycle, which your financial plan cannot predict, Emergency fund should not be used for leisure or holidaying or buying new and bigger gadgets when your gadget , some typical scenarios for using emergency funds are below
- Household expenses in case of unexpected job loss
- Financing travel in case of emergency in family
- A large car repair not covered fully by car insurance
- Co-pay obligation on health insurance in case you health plan doesnot fund it
- Some Major appliance break down
How Big Should be your Emergency Fund
A classical emergency funds should be 6 months of your expenses , while this sounds simple the tricky part is to figure out what to include in these expenses , typically you can pick up your past 6 month expenses and than add a multiple of 10 % inflation and keep that as emergency funds,or you can list down all the key expense heads and project what money you require for each of them, this can include groceries, utilities, entertainment, mortgages, insurance etc.
Key Requirements of an emergency funds
- Zero Risk : Emergency funds should be parked in assets which have zero risk, In most cases what this means is that you will have to contend with lower return, but primary priority for emergency fund is assured availability whenever you require it, Savings accounts, Fixed deposits, recurring deposits etc.
- Liquidity : Liquidity is paramount to any emergency assets you create all your investments in emergency funds should be in instruments which are 100 % liquid,
- Accessibility: If there is an emergency, you need your money immediately any asset class which gets you money immediately, for example Fixed deposits may take time, short term debt funds also take 2-3 days to get money into your account.
Which Asset class to use for your emergency fund
Emergency fund is an important pillar of any good financial plan, At bodhik we recommend that you break emergency funds into 2 parts
- Short term emergency funds : Keep it mostly in cash in sweep account and liquid funds
- Long term emergency funds: Keep it in a mix of FDs and Short term debt funds
We also recommend you to carefully analyze your expenses to identify the right size of emergency funds, and lastly never get greedy with assets you invest in.