What is all the fuss about?
What does it even mean?
Why is it so important?
Do we all necessarily need to focus on this?
I’m just 20, I don’t need to worry about this.
All of us have these questions running in our heads when we think of a Rainy-Day Fund.
So, let’s dive right into it.
What is a Rainy Day?
A rainy day is a time of need or trouble.
It is when life throws you a major curveball and you’re not in a position to generate income from your business or job to deal with the unexpected circumstance. It is a time of revenue shortfalls or a budget deficit, which means that money coming in through your regular sources of income is not enough to meet your daily living expenses or the emergency that has landed at your door.
A few examples of a rainy day would be:
- A job loss or a layoff.
- Change in government policies impacting your business or any crisis impacting profit generation and running of the business.
- A terminal illness or an injury that’ll prevent you from working for a while.
- A car breakdown.
- A major repair at home.
- Unexpected travel due to family emergencies.
Not to forget the major international crisis that the Coronavirus pandemic has created which has halted or interrupted all operations and impacted every single human being.
What is an Emergency Fund?
According to Wikipedia, “A Rainy-Day Fund is a reserved amount of money to be used in times when regular income is disrupted or decreases in order for typical operations to continue.”
It is a readily available sum of money to help one in times of financial dilemma to meet basic expenses. This is a financial safety net for unexpected/unavoidable expenses and future mishaps.
So, How Much is Enough to be kept aside as an Emergency Fund, you’ll ask.
Follow these simple steps to determine the absolute amount of this fund.
Step1– Get organised and define a list of emergencies that could arise. This would help in two ways: 1. You would be able to determine the approximate value and 2. You would have a list of activities/events that can be called an emergency when this money can be used. Because hey, this shouldn’t be used to cover the shortage in funds for that holiday you’ve been planning or to sneak in that extra meal out.
Step 2– Go through your budgets & expenses for the last 4-5 months. What is the amount of money that you spent to meet basic expenses that cover your essential needs? How much money would you, without a choice, have to spend on rent, utility, food, etc.?
Once this amount is determined, you’ll have a clear picture of the bare minimum sum of money required to survive.
Multiply this amount by 6 and there you go. You have the amount that you’d need to set aside.
A risk averse person or someone who is in a fluctuating income or unstable job/business should definitely have 6 months of expenses put away.
For someone who is in a steadier job and has a bigger risk appetite willing to take more risks, a bare minimum of 3 months must definitely be kept aside.
When to begin setting aside money?
NOW is the right time.
Whether you’re 25 or 35 or 45, if you haven’t started putting a sum away, you must begin NOW.
How should I set aside the money?
Start by putting aside small sums of money if you don’t have the bandwidth to set aside a lump sum.
Even INR 1000 per month is good enough to begin with. Try to increase this sum as you move forward until you achieve your goal.
Mummy gifted money on your birthday? Maybe you can put half of it in the Emergency Fund.
Spare change in your piggy bank jar? What are you waiting for?
Found some money in your jeans pocket? Put that in too.
Your aim should be to sprint towards building your Emergency Fund.
Once this is achieved, you can focus on other goals and save up for those.
Where should I keep this Fund?
The main goal of this fund is to meet an emergency or an unexpected expense.
Hence, it’s very important that you focus on the liquidity of these funds.
You should be able to withdraw money when you need it without delay.
If invested in a financial instrument, these two factors must definitely be taken care of:
- There should be no penalty for early withdrawal.
- There should be no volatility or the value of the amount should not go down.
Ideally, since emergencies are about quick access to money, one should hold all of the fund in the form of cash. However, looking at it from an investment perspective, that would be an inefficient way of managing it. It is highly unlikely that the total fund would be required all at once.
As a typical rule of thumb, you should save your funds as below:
- Cash: It is important that a part of your savings is kept in cash as it is the most liquid form of saving. It does not involve any loss in value except that of Inflation.
- Savings A/C: A part should be kept in your Savings bank account as it offers an advantage of interest and is still highly liquid. Banks offer returns of 4-6% p.a. and Interest Income from a Savings A/c is tax free up to Rs 10,000 every year.
- Liquid Debt Fund: The remaining amount should be invested in a Liquid Debt Fund. It offers better returns (6-8% p.a.) compared to both Cash and a Savings A/C. However, it involves some risks like interest rate risk, credit risks, etc. The Gains from Liquid Funds held for 3+ years, falls under Long Term Capital Gains and is taxed at 20% with indexation.
- Fixed Deposits: A portion of your emergency could also be invested in a Fixed Deposit or a Recurring Deposit. However, they offer a rate of return (3 – 6.5%) similar to a Savings A/C and have a minimum tenure where the money needs to be invested. Early Withdrawal of an FD attracts a penalty and lower rate of interest. FD interest income is added to the total income and taxed based on the income slab you fall into.
The way I like to typically split my funds is as below:
Savings A/C: 25%
Liquid Debt Funds: 50%
The importance of having a Rainy-Day Fund cannot be stressed enough.
Think of it as an insurance policy. Rather than paying huge premiums to an insurance company, you’re setting aside money for yourself that can be used at a later date. This money can be accessed quickly and easily if some unfortunate event occurs.
Having a fund readily available will prevent the use of High Interest loans and will save you the horror of Credit Card Debt, which is the easiest to fall back on during a crisis.
So go ahead,
BE FOCUSSED and
LIVE BELOW YOUR MEANS to set up that Emergency Fund.
Treat it as much a necessity as you treat your iPhone or that Gym Subscription or the quick getaway that you sneaked in on that long weekend.
Get Going NOW!!!