The Concept & Advice on Emergency Fund

Mr. Gerard Colaco: The financial plan of every individual and every family must be built upon a solid foundation of safety and security. Only after safety is ensured, do we venture out looking for higher returns.

When the risks of death, disease and damage to property are taken care of through regulated institutions, it is called insurance. Apart from this institutionalized insurance, every individual and family must have their own 'private' insurance in the form of a reserve of money to meet emergencies. Such a reserve is called an emergency fund.

The emergency fund must be deployed in highly liquid avenues of investment like savings accounts or money market mutual funds. Returns are not important here. Liquidity is. Only such avenues of investment must be chosen, which can be encashed within 24 hours. For your emergency fund, a separate investment account must be opened. Never should an emergency fund be confused with your normal bank or investment accounts.

In India, the banks offer 'flexi deposits', which are well suited for emergency funding. A small portion of the flexi deposit is treated as balance in a savings account. The rest of it is treated as a fixed deposit. For example, if you have a Rs 1 lakh flexi deposit, Rs 10,000/- out of this, may be considered being in the savings account at 3.5% for a resident Indian. The remaining Rs 90,000/- will be considered to be a fixed deposit at a rate of interest which may be twice the SB account interest.

Now if you want to write a cheque for Rs 50,000/-, you can do so without going to the bank and prematurely redeeming the fixed deposit portion. Of the Rs 50,000/- that remains, Rs 5,000/- will now be in the savings account and Rs 45,000/- in the fixed deposit account. You can also add money to this account whenever you want, just like in a savings account.

The important thing is that it should be a separate account and you and your wife should know that this has been set apart as an emergency fund. Furthermore, the emergency fund should perforce be in joint names, operable by any one of the joint holders. In case you have a minor mishap and cannot sign, the joint holder should be able to operate the account on his/her own.

An emergency fund is sacred. It should never be touched unless there is an actual emergency to your family. The cumulative effect of interest being added back and compounded will help the fund keep pace with inflation.

What should be the size of the emergency fund? There is no simple answer. A good thumb rule based upon common sense and our own experience is that at least 12 months of normal living expenses should be in the form of an emergency fund. You will by now be familiar with the concept of normal living expenses. For example of a family with expenses of Rs 25,000/- per month, we would be looking at an emergency fund of approximately Rs 3 lakhs.

Never think of an emergency fund as an unproductive waste of money. You will know the value of emergency funding only when calamity strikes. In these days of increased uncertainty and rapid changes, an emergency fund has much more relevance and importance than say 30 years back. It is your first line of defence. Treat this as priority.