Save for a Rainy Day: Build an Emergency Fund

'Save for a rainy day' - a piece of advice often heard, a truism that doesn't need a pandemic to validate itself

And yet the pandemic gave us a first hand feel of the financial and emotional turmoil of losing jobs, shutting down businesses, caring endlessly for our loved ones.

Money is truly vital during emergencies.?

Some findings reported by Times of India on Indians' emergency preparedness:

(survey conducted by Finology on 3 lakh Indians)

• 75% of Indians don't have an emergency fund. They could default on their EMIs and bills in case of one!
• 29% said their salary does not even last 15 days?

One of every 6 Indians owes more than 2 times of what they own?

When asked how would they pay their EMIs if they run out of funds:

• 57% said by selling off their investments?
• 24% said by taking another loan?
• 5% said they would borrow from family and friends
• 15%? said they would skip the EMI’s?

One out of 3 Indians neither has a health insurance or an emergency fund?

A key insight from World Bank- Global Findex 2021 report on the financial well being of Indians was that they struggle to arrange emergency funds?

• Family and friends are the first source of emergency money for 30 percent of adults.
• More than 50 percent say they would borrow or sell assets in an emergency. In contrast, 50 percent of adults in high income economies say they would mainly use savings to come up with emergency money.

What is an Emergency Fund?, what is its relevance

An Emergency Fund is the kitty that we stash away for that proverbial rainy day?

It is a contingent fund that we build to help us with finances when emergency strikes?

Financial Emergencies can crop up in the following situations:

1. Loss of a job
2. Responsibility of providing medical attention to near/dear ones
3. Natural calamities like a cyclone, floods etc.
4. Unexpected Travel
5. Unexpected Home/ property repairs?
6. Unexpected Car repairs?
7. Unexpected Pet care
8. Social gifting obligations for events, parties

When we don't have an emergency fund, we respond to such situations by?

1. Borrowing from family or friends
2. Breaking our high yielding long term investments?
3. Taking high interest debts via credit cards, personal loans etc.?

None of the above situations make our financial life or personal equations any better.?

Especially the credit card debt when we start paying 40% per annum on the outstanding amount!

How is an emergency fund different from investments or insurance

An insurance helps cover life or health or medical expenses but does not cover all types of financial exigencies.

An investment fund is what one sets aside for our long term or short term goals.?

On the other hand an emergency fund is designed to help survive many unforeseen situations that could cause financial strain.

At the same time the key objective while building this fund is to choose low risk, highly liquid investment options. Such options invariably yield lower returns as compared to a purely investment fund.?

How much to save in an emergency Fund?

Emergency fund should have enough to tide one through 3, 6 or 12 months of financially tough times.?

Consider how much you need for survival:?

Include basic non-negotiable expenses like food, housing, utilities, transportation, childcare (including school fees), healthcare (including insurance) pet care and EMIs (equated monthly installments)

Build a corpus covering 3-6 months expenses if you:

1. Are single, or married with double income but no kids?
2. Have very low liabilities /loans
3. Have a steady job in a high demand industry?
4. Have zero dependents

Build a corpus covering 6-12 months expenses if you :

1. Are married with kids?
2. Are the sole bread earner?
3. Have dependent parents or relatives?
4. Have a freelancing, contractual job in a very competitive industry.?

8 Steps to help you execute building an emergency corpus flawlessly.?

Step 1: Decide how much money you want to save : 3x, 6x or 12 x of your essential expenses.

Step 2: Take a closer look at your monthly budget. Trim down some expenses to make room for a monthly contribution towards building this corpus.

Step 3: Decide the best instrument to invest in. Choose safe, quality investment options with high liquidity and low risk

Step 4: Now set up an auto debit from your account to this fund. Automating the saving process brings easy discipline to the plan.?

Step 5: Keep monitoring the account. See how much money is getting saved?

Step 6: Avoid the temptation to splurge. Say no to dipping into this fund for any frivolous expenditure?

Step 7: Replenish after use: Incase you withdraw for an emergency,? make sure to build it up back again with discipline?

Step 8: Once you have reached your target, divert funds to your long term investments planned for reaching financial goals?

How much time will it take to build the Emergency fund:

Let’s assume the monthly take home salary is Rs 50,000/-

And necessary expenses are 75% of salary i.e. Rs 37,500/-

Now, if you decide to contribute 15% of monthly salary to building the emergency fund corpus, then at 5% CAGR it may take you

• 15 months to build a 3x corpus (Rs 1,12,500/-)
• 30 months to build a 6x corpus (Rs 2,25,000/-)? and
• 60 months to build a 12x corpus (Rs 4,50,000-)

Of course you can always accelerate this by contributing chunks from annual bonus or incentives..

Where should you invest for your Emergency Fund

Choose short term investment options that offer both liquidity and low risk.?

• Savings account : Savings account can be a highly liquid option to build an emergency fund corpus. The returns may be as low around 3.5%?
• Fixed Deposits : While Fixed deposits offers returns in the range of 6.5%- 7% , there may be a penalty on premature withdrawal - hence a low score on liquidity?
• Liquid mutual funds : Liquid mutual funds are as the name suggest, highly liquid. These low risk investment option have yielded close to 7.13% on an average in the last one year (May31st 2024) They invest in high quality short term debt instruments with maturity of less than 91 days.?
• Arbitrage funds :?

Arbitrage funds make arbitrage profits through differential pricing of the same security in different capital markets.

Supposing a security trades at Rs 100 in the spot market and Rs 105 in the futures market , the fund manager buys it from the spot market and sells it in the future market to lock in the Rs 5 profit.

Similarly if a security trades at Rs 200 on the Bombay Stock Exchange (BSE) and Rs 210 on the National Stock exchange (NSE), the fund manager may buy and sell between the exchanges to lock in the profit from the price differential.??

As per SEBI, (Securities Exchange Board of India), an arbitrage fund must invest up to 65% of corpus in equity and equity related instruments. The rest are invested in high quality debt instruments like term deposits, debentures etc.?

Arbitrage funds have yielded upwards of 7.5% average returns over the last one year (July, 2024). They generally work best in volatile markets vis-a-vis range bound markets.

Additionally they are taxed as equity mutual funds. Profits made within a year of investment are treated as short term capital gains taxed at 15% . Profits over a lac made over a year plus of investment are subject to 10% capital gains tax.

Note : At LXME , we believe every woman should proactively plan for emergencies that may disrupt her financial well being anytime. Come join our vibrant community to know more. Do check out our Emergency Fund.