Here is a simple guide on Emergency Funds and why you need to get this ready before investing in equities or any other asset class.
Why Emergency Funds?
Life, at times, may bring up unpleasant situations where cash comes to the rescue. It could be an accident or a medical emergency, which might demand some money. If all the cash stays invested in equities or hard assets like properties or gold, then there might be occasions where you got to sell some assets to get hold of cash. This will also interrupt the compounding process of your assets if you disturb them by selling off. Thus, before investing in stocks or ETFs, or hard assets, it is essential to have an emergency corpus built ready to deal with the uncertainties of life.
The Pandemic has rendered many without jobs, and thus, there might be a temporary loss of income until one gets a new job. So, simply put, emergency funds come in handy to handle life’s emergencies.
We need liquid cash readily accessible without locking them into a high-risk financial instrument.
As expressed by Vanguard — Emergency funds are essential to combat:
- Medical emergency
- Vehicle accidents
- Sudden repairs/theft
- Job loss
- Illness and other life’s uncertainties.
An emergency fund is a stash of money to cover the financial surprises life throws your way. These unexpected events can be stressful and costly. Here are some of the top emergencies people face:
- Job loss.
- Medical or dental emergency.
- Unexpected home repairs.
- Car troubles.
- Unplanned travel expenses.
Where to Keep your Emergency Funds?
People waste enormous time to find the best place to park emergency funds. Some even open a new bank account to get a few % high on their deposits. Sad to say that one of my friends had parked emergency funds by buying a corporate bond which shall mature after five years — meaning he cannot touch the corpus for the next five years even in an emergency. The monthly payouts excited him to opt for such a financial instrument. The very purpose of high liquidity and safety is compromised for monthly payouts.
The only thumb rule is to adhere is to park where the funds can be reached in an emergency without any lock-in or not to wait to redeem the funds (liquidity risk) and loss of capital (investment risk). Say you end up in a situation where someone needs to be hospitalized. Do you think you will be able to access or redeem the bonds in such a scenario?
Thus, it is essential to park emergency funds where the sole aim is immediate availability (ideally 24 / 7 access & liquidity).
Do not chase higher returns
Do not waste time hunting best funds or banks
How Much should your Emergency Funds be?
There is no one straight answer, though we can consider six or twelve months of expenses. The amount to be parked as emergency funds depends on what stage of life or level of wealth ladder a person is in.
A young earner who has just started his career may not have enough money to get on with six to twelve months of expenses. Whereas, a person who has retired from his service may have (most cases) accumulated enough that he need to worry too much about emergency funds, as he might be on a different level of a wealth ladder.
Ideally, all routine expenses like food, groceries, rentals, subscriptions, fuel, medicines, utilities, and essentials to continue everyday life are accounted for under an emergency corpus.
As an example: If your monthly expenses are $1000, then:
six months expenses — $6000
twelve months expenses — $12000
If you have a mortgage, one may consider including at least 50% of the monthly mortgage on the emergency funds to be ultra-safe. It is just a personal choice and how conservative an investor is.
The emergency fund size will also vary based on the geographic location.
A person living in Hong Kong (assuming no mortgage or liabilities and living in their own house) may need just enough to cover living expenses which may be about US$1200. For twelve months, the total corpus shall be about US$15000.
A person living in India (assuming no mortgage or liabilities and living in their own house in Chennai) may need just enough to cover living expenses which may be about US$500. For twelve months, the total corpus shall be about US$6000.
What to do if you don’t have a corpus or enough money or just started a job?
You can build up to it by regularly stashing smaller amounts, like every week or paycheck. If you keep it consistently filling up your emergency bucket, you’ll eventually achieve your total emergency corpus over time.
For instance, let’s say you set aside $25 a week in an emergency fund. At the end of 2 years, you could have $2,600 saved. Increase that amount to $50 a week, and your savings could grow to $5,200. Make it $75 a week, and you’ll see an even more significant amount saved — $7,800.
What to do if you have more dependents?
Most people in India and other eastern countries take care of their parents as they are aged. Thus, the number of dependents may be more in many families, and in such cases, a conservative, thoughtful investor may allocate more to emergency corpus considering the number of dependents.
The image posted above is one of my friend’s father, who is challenged by cancer. Life, at times, comes up with different challenges, and all we can do is be prepared to face and overcome them. The reason why I posted the above image is mainly to emphasize those words marked in RED.
The importance of emergency funds and having insurance are only realized during an emergency and not when we are young.
What to do if you are an ex-pat living away from your home country?
It is not uncommon to see people migrating to foreign countries for work whereas the dependents or other family members continue to live in their home country. In such cases, the emergency corpus is needed in both locations.
A friend of mine lived in Singapore, and his dependent parents lived in India. Suddenly, there was a medical emergency in which the doctors suggested a minor surgery. Though health/medical insurance was in place, cash was required, and it took some time for him to transfer the funds. For this reason, a part of the emergency corpus should be made accessible if any dependents living in the home country.
I have maintained 80% of the total emergency corpus in the place I live and about 20% in my home country, both in simple savings accounts or time deposits that any family member can access anytime.
The corpus amounts to about 15 months of expenses and will keep topping up to match inflation.
What to do if you have used up your emergency funds to handle an emergency?
Once you have used up the emergency funds from the bucket, it is essential to get it filled again. You may consider filling it in stages as you get your monthly paycheck, or if you have a corpus, you can consider allocating a part towards emergency funds. Ideally, for a salaried person, filling it in stages will be an ideal way to go.
Should you consider Debt payments and other non-essentials into your Emergency funds?
Strictly speaking, it is recommended to pay off the debts directly rather than saving them as emergency funds, unless the debt levels are too high — like you had mortgaged a property where there is a small, consistent outflow of cash towards it.
I hope this blog was insightful and do share your thoughts and other interesting ideas on emergency funds.