It is important to have an emergency fund. But it is equally essential to keep emergency fund in right place.
What are the rules? Where to keep emergency fund so that it doesn’t get spent needlessly?
Emergency in life is one condition we all want to avoid.
But unfortunately the control is not in our hands.
The best we can do is to be ready to meet the emergency.
The worst aspect of all emergencies of life is that, they strike at the worst possible time.
And to make the matters worse, they are also expensive.
The last time I faced an emergency it cost me $1,500.
If I had not accumulated my emergency funds, the situation would have been even gruesome.
When emergency strikes, the last thing we want to face is a financial crunch.
Its essential to keep emergency funds in right place.
Where to keep emergency fund?
Funds required to meet emergency cannot be build in a day.
Better approach is to start keeping aside a fixed amount of money each month.
This way, over a period of time, small-small savings converts itself into a substantially big emergency corpus.
Putting aside these small sums of money may look unnecessary in the beginning.
But with passage of time, these very small amounts compounds to become a big corpus.
There is no more-effective way to build an emergency fund than starting early.
Why to keep an emergency fund?
Without an emergency fund, during emergency, one will resort to debt which proves very costly.
Some people also consider their retirement savings (provident fund etc) as their emergency fund.
People digg into their retirement savings to pay for health care, motor accident, sudden travel etc.
This is not the right way to handle emergencies. Risking ones retired life to manage emergency must be avoided.
Yes, people who have not build an emergency fund may not have any other alternative.
But why to land in such a situation?
Better alternative is start building emergency funds from day zero (today).
…Utility of emergency funds…
Personal finance management says that one must try to avoid getting into debt.
Emergency situations of life are a ideal breeding ground for people to get into the debt trap.
People are forced to take debts during emergency as there is no other way.
To avoid getting into debt, people must always maintain emergency savings.
Another problem with emergency is, one will never know how much it will cost.
So what shall be done? Is there any rule of thumb?
There are experts who say that 6 months worth of expenses is sufficient.
Suppose ones monthly expense is $2,000 per month.
Equivalent money to be put in emergency fund should be $2,000×6 = $12,000.
So $12,000 maintained as emergency fund should be sufficient to handle any emergency situation?
Well, the answer is unfortunately not yes.
One cannot generalise and confine emergency fund requirement to few months worth of expense.
Wiser alternative is to keep contributing each month to ones emergency fund.
The bigger the emergency fund grows, the better.
There is tendency of people to accumulate emergency funds first and then spend it on needless things at the end.
Its essential to also learn to keep aside the emergency funds so that one never gets a glimpse of it in day to day life.
So where to keep emergency fund so that it does not get utilised for unnecessary things?
One can keep emergency fund in a number of ways.
But no matter what way one selects, it must exhibit following parameters:
Emergency fund saving must be very liquid.
If it takes 3-4 days to liquidate funds, it means, it is not a good option to keep emergency fund.
Emergency fund should be kept in such a way that it can be withdrawn within 24 hours.
(b) Risk Free:
Investment risk builds up due to price fluctuation.
One cannot lock their emergency fund in options where prices remains volatile.
When people want to draw money during emergency they must do it without any obstruction.
Such situations are undesirable when invested money gets shrunk due to price volatility.
Hence, it is advisable to invest in debt linked options where returns are very predictable.
So, where to keep emergency fund?
(A1) Piggy Bank @ Home:
Yes, the best way to keep emergency fund is in your piggy bank.
Buy those clay made piggy banks which allows money to only to go-in.
To take money out, one must break-open the piggy bank.
No other option can match the liquidity of this option.
This option is a zero return (interest) option. But this is the age old methodology which works even today.
(A2) Savings @ Bank:
No body will doubt that keeping money in savings account is ideal for keeping emergency funds.
It not only provides liquidity (ATM withdrawals) but also earns risk-free interest.
Though the interest earned is too-low but still its better than piggy banks.
But people do tend to spend money kept in saving account.
What can be done to better it?
Best alternative is to maintain a separate savings account to keep emergency funds.
Return its ATM Card back to the bank. Just keep the cheque-book and use it during need.
(A3) Recurring Deposit @ Bank:
If one does not want to open a separate savings account to keep emergency funds, recurring deposit comes for rescue.
We can use our existing savings account to build emergency funds most effectively.
It allows one to transfer fixed amounts of money on regular intervals (monthly) as recurring savings.
The regular fund-transfers build the emergency corpus very steadily .
And the best part is, it earns high interest (like fixed deposit).
(B1) Health Insurance @ Bank:
Good health care has become very expensive.
No matter how heavily we contribute to emergency funds, there is always a chance that it will fall short.
In such a situation, best alternative is to buy a pure health insurance plan.
The earlier (age) one takes the health insurance, more cost effective it will be.
(B2) Motor Insurance @ Bank:
These days people keep multiple vehicles. With increasing traffic on roads, there are more incidents of road rage.
Growing road rage is causing more motor accidents.
In these scenario’s it is always better to maintain a motor insurance.
(C1) Gold @ ETF:
Since ages, people treat gold as an investment heaven.
Gold ETF is my personal favorite. Though I will not suggest to keep more than 40% of emergency fund in gold.
Why gold ETF?
In long term, price appreciation of gold beats inflation for sure.
Even in short term, price fluctuation of gold is not too much.
Does this parameter make gold ETF an ideal option for keeping parked ones emergency funds?
The ease with which one can buy and sell ETF’s makes it a comparatively liquid alternative.
The ease with which one can buy and sell gold ETF is much better than physical gold.
One can redeem gold ETF within one day.
Except on weekends and stock exchange holidays, gold ETF’s can be redeemed with click of a button (online).
(C2) Money Market Fund @ Mutual Fund:
These are one of the safest investment vehicles. Hence it is also a ideal choice for keeping emergency funds.
Generally, money market funds invests only in government issued securities.
They also buy securities issued by banks and corporate.
Money market generally does not accept investment in small sums of money.
This is one reason why common men does not talk about money market a lot.
But mutual funds provides the opportunity for common men to enter this market.
Money market linked mutual funds comes as a big relief for people carrying high emergency funds.
In long term money market funds can give returns of 8-9% per annum.
This automatically makes money market funds as a preferred choice.