One of the initial steps in the financial planning process involves taking care of unforeseen risks or emergency situations which emerge uninformed or need immediate action. Besides getting protected by means of health and life insurance, a person needs to create a corpus so as to meet any other financial risks/expenses – be it for meeting the household expenses for over a month or honouring commitment towards loan EMIs etc.
This corpus which needs to be created is called an Emergency Fund. Before starting to invest for long-term goals, one must have a proper emergency fund in place. The best way to deal with emergencies is to have some money safely put away which can be accessed quickly and inexpensively.
A few important pointers about emergency fund:
- It is savings parked in easily available liquid options which come in handy when unplanned and unexpected expenses arise.
- It enables one to pay for living necessitiesthat cannot be obtained through current income sources.
- What differentiates an emergency fund from other investments is liquidity, or the ability to turn the investment into ready cash.
- Financial experts advise that an emergency fund should be able to cover three-to-six months of living expenses. At Dilzer, we follow this following thumb rule – In case both spouses are working- an emergency fund equal to 4-6 months of one’s living expenses and liabilities are considered. In case only one spouse is working an amount equal to 6-8 months of one’s living expenses and liabilities should be apportioned.
Reasons why one needs an Emergency Fund
Many people completely overlook the need to build up an emergency fund. But what happens if suddenly one is hit by unforeseen events and needs a large amount of money? The person will be forced to rely on credit cards, take out a loan or access the funds set aside for retirement account.
1. Job change/New job
A person (or his/her partner) may want to change the current job. The ideal job comes along, but there may be a period of time when the person is not having an income
However one cannot afford to be out of a pay check for 1 week or even more! An emergency fund helps to cover for such period of time and the related expenses.
- Job loss
This is listed as the primary reason as to why one needs an emergency fund. Many a times one may lose job. Even if the person starts to look for a job immediately it requires some time to get another and one needs to cover for the expenses incurred during the period when there is no job. And, if the length of unemployment lasts for a longer time one probably needs to build a bigger reserve.
- Pay cut or reduced hours
Such occurrences may be temporary, but until one can figure out how to replace the lost income, an emergency fund will help soften the blow of the lost hours/pay cut.
- Unexpected home repairs
Sometimes, there will repairs needed in the house which needs immediate action and might be a very costly affair. A huge repair cost could uproot one’s entire financial plan. Hence one needs enough cash to cover for such expenses.
- Unexpected one time/ short-term medical expense
Such expenses can include cavities, root canals, appendectomies, stitches, wisdom tooth extractions, and numerous other medically necessary expenses which may come up suddenly and drain a bank account very quickly. An emergency fund in place helps to take care of all these.
- Unexpected long-term medical expense
An unexpected diagnosis can be a life-changer. Unfortunately, these are expenses that do happen. Though eventually one will re-work the budget to include paying for the monthly medical needs, but in the beginning, there are a lot of expenses for tests, samples, specialist visits, second opinions, etc. that happen very quickly and needs to be taken care of.
- Immediate need to move
No matter what the reason, sometimes one may need to relocate and that too, on a short notice. Moving expenses can drain the bank account very quickly. Having an emergency fund will make the move smoother.
- Car repairs
People generally have the habit to use credit card to pay for repairs in case the car broke down all of a sudden. An emergency fund should be the ideal option to take care of such expenses, especially if the bill is of a higher amount.
- Bigger-than-expected/surprise tax bill
This is one of the unexpected expenses that prompts one to create an emergency fund, particularly if the surprise tax bill leaves the account balance very low.
- Unanticipated travel
A death/illness in the family may force one to purchase a last-minute plane ticket at an exorbitant price for a flight to the place where it has occurred. One need not worry about such instances if there is sufficient cash in an emergency fund to pay for the bills quickly.
- Death in the family
It is especially difficult if the death is of the primary breadwinner of the family.
One needs to be prepared for the worst and take such unforeseen events into account and have an emergency fund in place.
These are just a few issues that can crop up in anybody’s life, leaving one short of funds. Any of these situations can cause a stable financial situation to change dramatically, making one look around desperately for funds. No matter how financially prepared a person is, one can never discount the possibility of disaster striking. An emergency fund helps one to overcome such situations.
Finally, once one has created an emergency fund, it is very much important to revisit the emergency fund every now and then, and take stock of it. And one should never use an emergency fund for other purposes. It should be left aside only for that rainy day. If used, it must be replinished
Debalina Roy Chowdhury