Cutting down on a few wants to secure your tomorrow is called adulting. The financial talk hits you hard when you turn 20, but it is necessary. Many finance influencers and experts have been talking about prioritising building an emergency fund for a long time now via digital media. With the Covid-19 pandemic, the lens through which people look at their financial capability has changed. Now, more than ever, outlets for encouraging financial literacy have widened and diversified.
People have begun to talk about building their wealth and 'making' money rather than just ‘earning' it, which brings to mind Robert T Kiyosaki's rich dad, who taught him how to make money without even being physically present.
An emergency fund is a financial storehouse to be used during a crisis. After all monthly payments, loans, or EMIs have been paid off, it is a corpus equal to three to six months of expenses over some time. Once the regular monthly expenses are paid, a considerable amount is taken from the regular money flow and added to the emergency fund every month to reach the final goal. Somebody may consider spending on luxury experiences as a recurring expense while for others, it might just be an immediate expense like regular bills and debt payments. Everyone's approach differs based on their lifestyle and quality of life, which also affects the size of the emergency fund needed.
An emergency never announces its arrival, it just pops up as this pandemic did. Regular money flow could be interrupted any day and the fund could be used for safeguarding oneself from such unexpected interruptions.
The most common question that comes up at every emergency fund discussion is the use of credit cards or the alternative of taking on personal loans during a crisis rather than establishing another fund. It is crucial to understand that by choosing credit, you are voluntarily choosing to play with fire. It is borrowed money that brings uncertainty as to when or whether you will be able to pay it back. In India, credit card companies have an annual percentage rate (APR) of up to 41%. Personal loans impose interest rates ranging from 10% to 28%. Paying off the debt, as well as the luxury of being able to afford it, is much too significant a sum to rely on in an emergency. Having a financial corpus is a safer and smarter option that lends some thinking time as well.
Nevertheless, there are certain misconceptions about an emergency fund that must be avoided:
Your emergency chest shouldn’t be funding your next big house or dream vacation.
It should not cover health emergencies as that is the job of health insurance.
It should not pay for any vehicle accidents or urgent auto repairs as that comes under auto insurance.
You are not required to save for years. It is made in a few months and used during an emergency.
It is not a huge amount; it rather depends on your consumption and earning.
It should not be added to the fund before debt payment.
Optimised future planning requires funds to be spread out evenly. It needs to be invested in places that are capable of redeeming on-demand without compromising on the interest rate.
Funds can be partly kept in a savings account where the interest rate received ranges from 3% to 6%. Other than serving the liquidity requirement, it offers enough interest to park funds there. Some amounts can also be parked in government or corporate bonds that provide a good redemption facility, fund security and returns of up to 8%. If an emergency does not occur, you can stay invested in the debt funds for better returns. The capital gains are considered short term till three years and long term for a larger period. An interesting fact is that if you invest in debt funds for three years, your capital gains will be taxed at your income tax slab rate for the first three years, but after that, they will be taxed at a flat rate of 20% after indexation. Investing your emergency fund in stocks is not recommended because the principal balance is not guaranteed and there is a high risk of your capital depreciating due to the stock market's short-term influence. Placing your funds in a fixed deposit is also tactless as your money gets locked in for a fixed amount of time. In case of an emergency, you will have to break your fixed deposit which will lead to a penalty.
Emergency funds are today’s necessity. They prepare us better to fight the unexpected battles head-on and lend us time to think of better alternatives to deal with a financial catastrophe.