A serious illness or disability due to illness or accident can also hamper one's ability to earn for a prolonged period. When life throws nasty financial surprises your way, have a Plan B ready. An adequate emergency fund can help you tide over the crisis.
To a great extent, credit cards have done away with the need to have emergency funds. You can use them to tide over the emergency till you are able to arrange funds. But credit cards should not be seen as a replacement for setting up an emergency fund.
Financial planners usually suggest keeping aside six month worth of expenses for emergencies. However, this thumb rule varies according to individual circumstances. If you have health insurance, you won't need a contingency fund during a medical emergency. If it is cashless, you may not have to shell out even a rupee. However, be prepared for situations where you or a family member might not need hospitalisation, but will require money for doctor visits, therapies, tests and medicines.
The size of the contingency fund will also depend on how secure your job is and how many earning members are there in a family. You also need to take into account EMIs and insurance premiums that need to be serviced regularly. Households that are paying huge EMIs experience considerable financial stress when income reduces. Their emergency fund has to be that much bigger. An emergency fund goes a long way in servicing debt while alternatives like restructuring the outstanding loan is being worked out.
Where do you keep it?
After you figure out how big a kitty you need, you need to choose an appropriate investment option for the fund. Remember, returns are not important here. What is more critical is that the money should be easily accessible at short notice. Financial planner Malhar Majumder suggests parking at least 25% of the emergency fund in a savings bank account. You can withdraw it 24x7 (see box). Ensure you have a debit card with adequate cash withdrawal limit. Many people remain unaware of their debit card's daily cash withdrawal limit (usually `40,000) till the time they attempt to withdraw huge amounts during an emergency.
But savings bank accounts give very low interest of 4% on the balance. A better idea is to go for a sweep-in account where excess funds are automatically transferred into a fixed deposit and earn higher returns of 7-8%. When you withdraw, the money is paid by breaking the fixed deposit. If your bank does not have a sweep-in facility, you can put the money in a fixed deposit that can be broken anytime.
The other reasonably comfortable option is to park your cash in liquid funds. The money will earn a decent return and can be withdrawn at any time.Liquid funds have returned 8.24% over the last one year and ultrashort-term funds have returned 8.52% during the same period. Re demption takes a day. Some fund houses, like Reliance Mutual Fund, offer liquid funds that come with ATM cards so the investor can withdraw the money directly without the redemption first going to his bank account.
A contingency kitty once formed is not the end of the process of providing for a rainy day. You need to revisit the fund and replenish it regularly to adjust for inflation, lifestyle changes, increase in family members and changes in debt commitments. The kitty should be reviewed at least once a year.
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