Not An Option But Necessity: Understand The Importance Of Emergency Fund In Your Financial Life
It's often the rainy days in life that remind us of the importance of having an umbrella, right? Just like that, the past two pandemic-hit years have been a reminder for us of how unpredictable life can be.
While COVID might have taught many of us about the importance of insurance, another key lesson that not only the pandemic but even the recent mass layoffs have taught us is the importance of an emergency fund.
Even if you have insurance, investments, savings, etc., having a separate and adequate emergency fund is an absolute necessity in your financial life. Wondering why and how? Let's help you understand.
What Is An Emergency Fund?
An emergency fund, also known as a rainy day fund or contingency fund, is a portion of your savings set aside to deal with unforeseen financial difficulties in life. It acts as a cushion to help you tackle those emergencies in your financial life that are capable of temporarily hindering your regular inflow of income.
Such financial exigencies can be in the form of a sudden job loss, severe illness, disability, or significant pay cut. In all such adverse events in financial life, having an emergency fund is what can rescue you by helping you carry on with your recurring monthly expenses.
How Much Emergency Fund Is ‘Enough’?
While there is no hard and fast rule, it is usually advisable to have an emergency fund with an amount equal to at least six months of your recurring monthly expenses. The size can be even bigger, such as 9–12 times the monthly expenses, if you can maintain that size. After all, the bigger, the better!
Coming to the recurring monthly mandatory expenses, these can be your rent, utility bills, loan EMIs, monthly investment contributions (like SIPs), insurance premiums, your children’s education fees, etc.
So, for instance, let's take an example. If your monthly rent is Rs 20,000, utility bills (such as water, electricity, and grocery bills) are Rs 15,000, existing loan EMIs are Rs 25,000, and ongoing SIPs are Rs 10,000, your monthly recurring expenses are Rs 70,000.With these expenses, your emergency fund should amount to at least six times this amount, i.e., Rs 4.2 lakh. This amount should remain untouched until a financial emergency necessitates the need to use it.
What Can Be The Consequences Of Not Having An Emergency Fund?
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The absence or inadequacy of an emergency fund can land you in two situations.
Let's understand the first one. If you are among those who ignore the importance of an emergency fund under the misconception that your investments will bail you out when required, then just hit the refresh button on your mind and read this.
Redeeming your investments can have two consequences. Firstly, as most investments are made towards reaching a specific financial goal, like accumulating a down payment for a house or a child’s higher education corpus, relying on your earmarked investments to meet financial shortfalls during exigencies can lead to failure to achieve those set financial goals.
Secondly, if the investments that you rely on are market-linked, like mutual funds, you are in for more trouble in case you end up having to redeem them when your portfolio happens to be bleeding red, like in the case of market corrections or crashes.
So, if the financial exigency happens to strike during such downward market phases, you are likely to incur losses on your hard-earned money that was put into investments, just because you chose to turn a blind eye towards the importance of an adequate emergency fund.
Now, the second trouble you may be in for in the absence or inadequacy of an emergency fund is pushing yourself towards the awkward situation of borrowing from others, like friends, family, or colleagues. You may even have to resort to approaching financial institutions like banks to urgently get a loan during a financial emergency. And even that's no easy way out, as lenders may or may not lend you the loan, depending on your repayment capacity.
Moreover, if you have ongoing loan EMIs too, financial exigency in the absence of an emergency fund, such as a sudden job loss, can make you attract various penalties, and, at worst, make you default on the loan.
What If You Already Have a Large Bank Balance?
Even if you have sufficient savings or a big bank balance, it's always advisable to keep an emergency fund aside. This way, not only do you remain better prepared to tackle financial exigencies, especially the ones that hinder your regular inflow of income temporarily, but you also get to enjoy peace of mind, knowing that you have a sufficient cushion to fall back on if any unforeseen financial exigency arises someday in life.
Where To Park Your Emergency Fund?
As emergencies can strike at any time, your emergency fund should be kept in a liquid instrument like savings accounts with high interest rates (like small finance banks and some private sector banks) or liquid funds (a category of debt mutual funds). You may keep your emergency fund in bank FD too, as nowadays, one can not only open but also close/redeem FD online through mobile banking or netbanking itself quickly.
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