Your laptop crashed and needs to be replaced. Your friend's father had a minor heart attack and needs some intensive care. Events like these come unannounced and typically set you back financially.
What do you do when these unforeseen events strike and you require immediate cash? It's precisely for these situations that you must create a contingency fund-a fund that you can bank on during emergencies.
|What do you do when unforeseen events strike and you require immediate cash? It's precisely for these situations that you must create a contingency fund|
Says Viraj Ghatlia of IL&FS Investsmart: "A contingency fund gives you the leeway and helps individuals to counter these emergencies. It's like insurance." Emergencies require you to be financially prepared and have ready cash at your disposal.
Money in the Bag
How much contingency fund you require depends on your financial situation and expense habits. If you are repaying mortgages or have a car or other loans, you should also account for these expenses when creating an emergency fund. Most financial planners suggest that about five-to-six months of expenses, including EMI repayments, should be your ideal emergency target. But there's no thumb rule. You can cut back on your emergency fund if you find it's too big and unnecessary. Says Ghatlia: "After assessing expenses, if one finds that the emergency fund has more cash than required, reduce the funds as per one's requirements. Each individual will have a different requirement. The idea is to have a comfortable fund situation."
For an emergency fund, don't use a normal savings bank account. Most investors traditionally use the savings bank account but the returns here are 3.5 per cent. Further, investors will not be able to maximise their gains here. The rate of interest in a savings account is calculated on the lowest balance of the month. So, even if you had an average balance of over Rs 2 lakh in your account, but your lowest balance was Rs 50,000, banks pay you an interest only on Rs 50,000 for that month. Which is why, the humble savings account may not be the best place for you to park your emergency savings.
Where to Stash the Fund
Emergency funds need to be accessed easily and quickly, so keep it in a liquid fund. This is easily accessible and the returns are reasonable at around 7 per cent per annum. Besides, there's no entry or exit load so there's no penalty here
Don't keep too much of your emergency fund here as you can easily be tempted to spend it. Besides, the interest rate on this form of savings is only 3.5 per cent per annum. Use this account only for day-to-day expenses
Bank Fixed Deposits
Returns on bank fixed deposits are around 7-8 per cent per year, but the interest is taxable. Breaking an FD prematurely attracts a small penalty and lower interest. You may not want to park too much of money here. But since the money is locked for a period of time, you won't break it except for a real emergency
How Much Do You Need?
- There's no one-size-fits-all. This depends on your individual financial situation
- Examine your situation and your income and expenses
- Ideally around six-monthly EMI payments on your home and cars should be enough
- Also, keep aside around two months' living expenses for daily use
What's important is that investors can sock away consistently in a liquid fund. Returns here are higher than normal banking account by 300 basis points. On average, liquid funds return about 7 per cent in the market per annum. Says Ghatlia: "The whole idea of emergency funds is that it should be liquid.
At the same time you want to ensure that it works for you. Liquid funds are best for starting an emergency fund. They match the criteria of quick and easy access to your funds and at the same time they deliver better returns." Liquid funds score on two fronts: they are immediately accessible, but unlike a checking account, one is not tempted to withdraw it for small setbacks.
Another option is to invest in a floating rate fund. They are more tax efficient than a normal liquid fund as it attracts a dividend distribution tax. The expected yields in a floating rate fund are similar to a liquid fund at around 7-8 per cent.
Bank fixed deposits don't make the cut. They are locked-in for a length of time, and premature withdrawals attract a penal interest of 1-2 per cent. Income funds and other debt funds may also not suit the idea of an emergency fund. Says Ghatlia: "The objective of an emergency fund is not to make money on the fund. As you move towards income funds, you are changing your priority from an emergency fund to a return-oriented fund."
Another strategy some financial planners suggest is to keep small amounts in liquid funds, say about two months' expenses, and the balance emergency fund in low-tenure fixed deposits of one or two months. This can pay-off only if the fixed deposit rates are higher than the liquid fund yields. Banks offer around 6-7 per cent for short-term deposits. Liquid funds are a shade better at 7 per cent. At times a sudden fund requirement by banks can drive up short-term interest rates. This is a time when you can make your financial move to an fd.
The Debt Options
In extreme cases, debt can come to your rescue. Banks are more than willing to lend if you have a good credit history. If you have sufficient collateral, such as fixed deposits or shares, the interest rates are lower than, say, a personal loan or a credit card cash withdrawal. Your best bet is the bank overdraft. Although often ignored by many investors, it's amongst the best options. On fixed deposits, banks usually extend about 80-85 per cent credit as overdraft. The interest charges are cheap, usually higher by about 2-3 per cent over your fixed deposit. But interest is not charged if you don't use the overdraft facility. Creating an overdraft facility, however, requires you to pay a small fee to the bank. Investors with bank FDs can make the best use of it.
Loans against shares and other certificates like the NSCs (National Savings Certificates), and Kisan Vikas Patras are cheaper compared to a personal loan. The interest rate is about 12-14 per cent per annum. As far as possible, avoid taking the personal loan. These are usually big amounts and the interest rate is around 18-24 per cent per annum. Never use a credit card for emergencies. Of late, banks have increased the risk-weightage on credit cards, and that has seen interest rates here increase to around 45 per cent per annum. Defaulters are even charged 50 per cent.
But again your best option is to create a cushion for yourself with an emergency fund, as debt comes at a cost. The interest you pay on the debt can delay your financial goals. On the other hand, creating the contingency fund may seem gruelling in the start, but can become easier if you maintain a discipline. When you can tide over a rough situation with your own financial resources, you will find the going worth it.