Last Updated on April 27, 2021 at 10:47 am
Sunder asks, “dear Pattu Sir, I just finished the re-assemble (basics of money management series). You had discussed the importance of an emergency fund. May I know how much I should allocate for an emergency fund?” To answer this, we must first understand both the purpose and limitation of an emergency fund. The answer to this question would be something like three months expenses or six months expenses. That IMO is not insightful to the young earner. We can do better.
My earliest memory of an emergency fund was when I saw my parents sit down and distribute their monthly income into different envelopes and boxes. One of the boxes was labelled ‘Extra’. This was meant for any additional expenses that occurred in the month. When my wife and I took over distribution, we called the box “Rainy day fund” and found that it rained once a month without fail. We had to use this fund from the third week of each month. Only when our incomes increased (and expenses did not!) could we think of a proper emergency fund.
So what is the purpose of an emergency fund? (1) The day to day expenses of the household should not get affected because of an unexpected expense. Today with the incomes we earn, this may seem trivial to most people reading this, but this was the situation with our parents and still is with scores of people without social media presence.
To satisfy the first requirement, a buffer of at least 10% of a month’s expenses at all times in the emergency fund. You can keep this as cash at home (only those who have never met emergencies break their head about investing this). If we manage to increase this fund a little by little each month, soon we will have at least one month’s expenses built up.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
🔥Enjoy massive discounts on our robo-advisory tool & courses! 🔥
The next level requirement makes sense only if investments are streamlined into goals: (2) monthly investments should not get affected because of an unexpected expense. So having built up a fund equal to one month’s expenses, we can keep adding to it until it grows to one month’s take-home pay.
Do we stop when the fund hits this level? Sadly no. Just a single emergency can deplete this fund almost completely. So we keep adding. The third level requirement is to minimise redemptions from our investments. I have heard my parents say so many times, “we will take a loan from PF for this”. Our aim should be to avoid this.
You might have heard the term deductible used in insurance (often in health and vehicle insurance). If an insurance policy has a deductible of one lakh, then it will pay only if the total bill is above one lakh. Up to one lakh, we need to pay ourselves.
Our emergency fund is the deductible for our networth.
Any unexpected expense up to the value of the emergency fund can be handled without touching our networth (our savings, investments, belongings). Sadly life does not care about the size of our emergency fund. So if the expense is too big, we will either have to take it from the amount to be invested (present and future).
This is why all our investments should not be locked up in ill-liquid assets. We must be able to withdraw from them anytime. Let us also pray that people who advocate lock-in as a form of discipline in retirement planning never have to face emergencies higher than their deductible (assuming they have one).
So the answer to “How much should I set aside as an emergency fund?” is not “three months expenses” or “6 months expenses”. We must recognise the purpose of an emergency fund, and building it is a lifelong process. We hope and pray that it does not get depleted often. An emergency fund contribution equal to 5% of our income for life can make a significant difference.
Where to park the emergency fund?
Too many people spend too much time worrying about where to put their emergency fund. What do you need in an emergency? Quick access to cash. So some cash at home, the amount in an SB account, some amount in an FD (ok, ok, flexi-FD or whatever), some amount in a liquid fund, some amount in an arbitrage fund. Just as long as you do not worry about the cash at home not earning interest.
Some people want to know if they can use a credit card for emergencies. The answer is obvious. You must have the money ready to pay the card bill (if not now, in about 3-4 weeks). If you are a regular card user, then it would be better to have an additional card just for emergencies (why?). Some also use a charge card (from Amex) instead of a credit card. This allows big purchases if the card is used frequently, even if you have used the card frequently that month, but the card may not be accepted at all places.
🔥Enjoy massive discounts on our courses, robo-advisory tool and exclusive investor circle! 🔥& join our community of 7000+ users!
Use our Robo-advisory Tool for a start-to-finish financial plan! ⇐ More than 2,500 investors and advisors use this!
Track your mutual funds and stock investments with this Google Sheet!
We also publish monthly equity mutual funds, debt and hybrid mutual funds, index funds and ETF screeners and momentum, low-volatility stock screeners.
- Do you have a comment about the above article? Reach out to us on Twitter: @freefincal or @pattufreefincal
- Have a question? Subscribe to our newsletter using the form below.
- Hit 'reply' to any email from us! We do not offer personalized investment advice. We can write a detailed article without mentioning your name if you have a generic question.
Join 32,000+ readers and get free money management solutions delivered to your inbox! Subscribe to get posts via email! (Link takes you to our email sign-up form)
About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! ⇐ More than 3,000 investors and advisors are part of our exclusive community! Get clarity on how to plan for your goals and achieve the necessary corpus no matter the market condition is!! Watch the first lecture for free! One-time payment! No recurring fees! Life-long access to videos! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course! Increase your income by getting people to pay for your skills! ⇐ More than 700 salaried employees, entrepreneurs and financial advisors are part of our exclusive community! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos!
Our new book for kids: “Chinchu Gets a Superpower!” is now available!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook is for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Do you want to check if the market is overvalued or undervalued? Use our market valuation tool (it will work with any index!), or get the Tactical Buy/Sell timing tool!
We publish monthly mutual fund screeners and momentum, low-volatility stock screeners.
About freefincal & its content policy. Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on mutual funds, stocks, investing, retirement and personal finance developments. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified with credible and knowledgeable sources before publication. Freefincal does not publish paid articles, promotions, PR, satire or opinions without data. All opinions will be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
- Twitter @freefincal
- Subscribe to our YouTube Videos
- Posts feed via Feedburner.
Our publications
You Can Be Rich Too with Goal-Based Investing
Published by CNBC TV18, this book is meant to help you ask the right questions and seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now.Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want
This book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.Your Ultimate Guide to Travel
This is an in-depth dive into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, and how travelling slowly is better financially and psychologically, with links to the web pages and hand-holding at every step. Get the pdf for Rs 300 (instant download)