Imagine being struck by an unforeseen crisis – a medical emergency in the family, loss of job due to global pandemic or need for replacement of an old car that suddenly broke down, to name a few. What is your plan of action for these sudden major expenditures?
People handle these emergencies differently but there are serious caveats in almost all of them, except one.
I will borrow money from friends and family – The first and foremost thought that comes to people’s mind is to fall back on family and friends. While it could be a viable short term solution, it may cause financial burden on your loved ones, and in some cases strain personal relations.
I can take a loan from a bank – This is another valid option to address some immediate concerns. However, personal loans of this nature have very high interest rates and are considered bad debt. Hence, by the time you are done paying the loan, you would have paid a lot of money in interest cost.
I can liquidate my investments – This is a precarious one as a lot of these emergencies, such as losing a job, might be linked to economic downturns or generally poor economic conditions. If you were to liquidate your investments during this time, you are likely to undertake significant losses.
I have dedicated emergency funds – This is the best approach to dealing with emergencies and can be done easily by setting aside funds in savings accounts, liquid fixed deposits or liquid money market funds.
1. I will borrow money from friends and family
The first and foremost thought that comes to people’s mind is to fall back on family and friends. While it could be a viable short term solution, it may cause financial burden on your loved ones, and in some cases strain personal relations.
2. I can take a loan from a bank
This is another valid option to address some immediate concerns. However, personal loans of this nature have very high interest rates and are considered bad debt. Hence, by the time you are done paying the loan, you would have paid a lot of money in interest cost.
3. I can liquidate my investments
This is a precarious one as a lot of these emergencies, such as losing a job, might be linked to economic downturns or generally poor economic conditions. If you were to liquidate your investments during this time, you are likely to undertake significant losses.
4. I have dedicated emergency funds
The right approach: Emergency funds
Having sufficient emergency funds is one of the first few steps to prudent financial planning. While it’s advisable to start investing early to grow your wealth, it is essential that you build up your emergency reserve right at the beginning of your financial journey. This is critical to your peace of mind as well as to act as a financial cushion during unforeseen circumstances.
How much emergency funds do I need?
Your emergency funds should typically cover 3-6 months of your expenses. The bottom limit of 3 months is deemed to be the bare minimum to take care of emergencies. On the other hand, anything above the upper limit of 6 months of emergency funds is considered too high. This is because emergency funds are typically low-yield-low-risk solutions such as savings and deposit accounts, which provide a safety blanket and are not catered to growing your wealth. As such, it is better to put the funds in excess of 6 months to work using high return instruments that can help you achieve your goals.
Where do I keep my emergency funds?
The general rule of thumb is low risk and liquid funds.
- Low risk – Emergency funds should be kept in risk free or low risk options only. They shouldn’t be impacted heavily by market fluctuations as that would subject you to incur losses if you need the money during a market downturn.
- Liquid – These funds need to be immediately accessible during emergencies. Hence, having them in solutions with lock-in periods also defeats the purpose as you wouldn’t be able to withdraw them as and when required.
The key solutions that fit the above billing are:
- Savings account – This is the most common type of bank account which is completely liquid and makes withdrawals straightforward. The drawback is that they are generally low yield and don’t offset inflation. You could consider high yield savings accounts to reduce some of the impacts.
- Liquid fixed deposit accounts – This is a popular tool of savings. They are a great option for emergency funds as their yields are higher than that of savings accounts and usually close to the inflation rate. However, it is important to remember that the interest earned is still below the inflation rate and hence fixed deposit accounts are not meant to be an investment alternative.
- Liquid money market funds – This is a category of mutual fund that invests in liquid, near-term instruments such as cash, cash equivalents and short-term debt securities with high credit rating. Consequently, these funds offer high liquidity with very low levels of risk and yields that are comparable with fixed deposits, thus making for another great option to build your emergency funds.
How do I build my emergency funds?
Start with splitting your surplus into your insurance premiums, loan repayments, investments towards your goals and monthly contribution towards your emergency funds. While all these components are important in your budgeting, building your emergency reserves should not be compromised on for other expenses. Make sure that you are setting aside some amount into your solution of choice every month till you reach a healthy range equivalent to 3-6 months of your expenses. Once you are done building up your emergency funds, you can then direct the money towards investing for your goals.
Stay tuned for a holistic tool to help you plan your cash flow in the coming months and assist you in your financing planning journey.
It is critical that you have sufficient emergency funds to ensure unforeseen circumstances won’t put you under undue strain and throw you off-track from your goals. This will help to build a strong foundation for your financial planning and enable you to focus on the next stage of investing towards your goals with peace of mind.