How much should I set aside as an emergency fund?

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.

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.