What they don’t tell you about the “emergency fund”!

Published: March 10, 2022 at 6:00 am

The emergency fund or a stash of money that is meant to handle unexpected expenses is one of the building blocks of personal money management. Yet, many aspects of it are not obvious unless we have first-hand experience. A discussion.

First the basics: We recommend putting away 20% of your take-home pay until you have accumulated an amount equal to six times your monthly expenses and then continue adding 10% to it.

Please recognise that an emergency fund is neither saving nor an investment. It is a simple cash holding. You can distribute it in different places. Some at-home; Some in your savings bank or current account. Some in an FD; Some in liquid fund etc.

Never use a credit card to handle emergencies unless you can pay the amount before the next billing cycle deadline. And if you cannot, redeem some investments/savings or borrow from relatives or sell some gold.

As we say in the Facebook group, Asan Ideas for Wealth, there are two types of people in this world. Those who have seen emergencies and those who have not. The former focus on ease of withdrawal and quantity. The latter focus on “returns”. Life can be a harsh teacher.

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    Now why an emergency fund is recommended? When we have just started earning, our net worth is close to zero. We need to accumulate a small stash of cash quickly to handle emergencies.

    So what is it that they don’t tell you about the emergency fund?

    1) A emergency fund is necessary but (need not be) sufficient. Say you just got your first salary last month and put away 20% of your take-home in an SB account. The next day, you have an unexpected expense = 40% of your take-home. What will you do?

    The first choice is to borrow from close relatives who are likely to offer you an interest-free loan and who you can pay back in instalments. Then you can consider selling stuff! Your bike; your mobile; some gold in the house etc. Options like a personal loan should only be used as a last resort.

    In 2006, when my late father was hospitalized for the first time, I was a zero in money management. We had no health insurance and no emergency funds. My brother-in-law gave us an interest-free loan of 1 Lakh (for a start!). That was the first time I ever saw that much money. I told myself I should never ever find myself in such a situation (borrowing from relatives). It took me more than 5 years to get there. Everything needs a spark and that was my spark to learn about personal finance.

    I hate to write it but another emergency can strike when you are paying off the loan obtained for the first emergency!

    If we are lucky for a year or two, we can build a reasonable rainy day fund. This will allow us to continue investing without a break or without redemptions. Even if a small unexpected expense hits us, it is important to immediately replenish the fund at the cost of investing less for a few months if necessary.

    2) “Six months expenses” is only a thumb rule!  Don’t believe it. You need more! A lot more. A single hospitalization is all it takes to learn the hard way. Whether you cover it with a corporate cover or individual mediclaim policy, you will need about 10-15% of the bill to cover for “non-medical expenses”. These include any non-medicinal accompaniments like gloves and personal care products. Such extensions could continue even after the patient comes back.

    If your income (or job) is not stable and you wish to service a loan, ensure you have at least 2-3 months EMI stashed away over and above the “usual” emergency fund.

    3) Your emergency fund is your net worth!  People often ask, “how much should I allocate as an emergency fund? Six months (6X) worth of expenses or twelve months (12X) worth of expenses?”

    The truth is, 6X or 12X is merely the amount you allocate to cash. Your emergency fund at any point in time is your net worth! Hopefully, much of it is liquid and not locked up in real estate!

    Suppose your monthly expenses are Rs. 30,000 and you have an emergency stash is ~ 6X or about two lakhs. You have built this up over two years or so and in this time, your investments have grown to about four lakhs. You get an unexpected expense of Rs. 3 lakhs. What will you do?

    Redeem 2L from the stash and redeem 1L from your investments. But now your rainy fund has hit zero. So you will have to start rebuilding again. You cannot spend another two years to build it back to 2L. You will have to reduce your investments and divert them to the fund.

    So what is the lesson here? We don’t know the extent of unexpected expenses. At any point in time, we should be ready to combat them with our entire networth. As our net worth grows, all this 6X, 12X business pales into insignificance. Most of our net worth should be liquid. That is not locked up into real estate, pension plans etc. Also see: Can you handle it when your entire wealth becomes an emergency fund?

    4) The worst kind of financial emergency is an unexpected recurring expense. An emergency fund will not help you there and money management will go for a toss. When my mom fell down and broke her in Feb 2014, I had to hire a caretaker to tend to her during the day. Therefore monthly expenses suddenly increased by a significant amount. Investing enough for long-term goals became a challenge for more than two years. We still have the caretaker coming.

    In summary, an emergency fund is an essential component of our daily lives. Just don’t expect life to throw at you proportional surprises. Once our net worth grows, we can breathe a lot easier. Until then, fortune and providence play a big role.

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