When layoffs and pay cuts abound, how large should your emergency fund be?

Dev Ashish

A common advice handed out freely to investors is to have an emergency fund.

It might be referred to via different names but the idea is simple – an amount set aside specifically for unplanned, urgent, unexpected and real emergencies that cannot be paid for with insurance or other means. Some examples can be a temporary job loss, medical emergencies that are uninsured, unexpected travel for family emergencies, etc.

The usual thumb rules

When asked about the size of emergency funds, the common advice is to keep at least 3-6 months’ basic living expenses as an emergency fund. These can include expenses such as rent, loan EMIs, food, school education fees, utilities, fuel costs and insurance premiums.

But this typical advice is a preliminary thumb rule for the size of such buffers. In reality, it is quite possible that some individuals would require a bigger emergency fund.

Why? Because of their unique situations, the size of the emergency buffer has to be somewhat bigger to ensure complete financial security for such individuals.

Let’s see what factors need to be considered to assess if a person requires a larger buffer.

- Nature of employment: If you have safe employment with no fear of job loss, then you can live with a smaller buffer of up to three months’ expenses. But if you are part of industries/sectors that are prone to layoffs and where opportunities are fewer, then ideally you need a bigger cushion. So the standard 3-6 month advice should be adjusted according to the threat of job loss and the probability of getting a new similar job quickly. Something like 6-9 months or even up to 12 month’s expenses can be considered in such cases.

- Earning members in the family: If you are single earning member of the family, then obviously your family’s finances face the risk of a single point of failure. So, it is better to first reach a six-month emergency fund quickly and then keep adding more to it gradually to increase the cushion for the family’s expenses. Something like 9-12 months. On the other hand, if both spouses work and the risk of simultaneous job loss is very low, then having 3-6 months’ buffer is good enough.

- Other factors: Let’s say you have ageing parents (or in-laws) who are partially dependent on you for ad-hoc medical expenses. In such cases and if their health insurance isn’t sufficient, then you need to keep some buffer for their expenses as well. This layer of buffer can vary on the basis of parents’ dependency and medical requirements.

These are just a few primary factors to consider. It’s possible that given a person’s unique situation, factors other than the ones above may also play a part.

Other factors to consider

For example, when I quit my salaried job several years ago to become a SEBI-registered fee-only investment advisor, I wanted a larger-than-usual buffer to give myself a sufficiently long time to build my business. So I had a buffer of almost two years’ regular expenses with me (in addition to long-term savings).

As for the question of where to invest the emergency money, importance should be given to liquidity and safety first. Generating returns isn’t the main factor for emergency funds. But, in general, a combination of savings account, fixed deposits and liquid funds is sufficient.

Some feel that they can get away with keeping a minuscule (or even zero) emergency fund as they have access to credit cards.

What these people ignore is that credit cards no doubt provide a line of credit that can come in handy in emergencies. But when the interest-free period is over in a few weeks, the money has to be paid back eventually. That too in full to avoid exorbitant interest rates (up to 40 per cent). And if a person then has no buffer or emergency fund, then how will he suddenly find the money to clear off those credit card dues that were taken for handling emergencies?

So credit card or no credit card, the buffer will be needed eventually. A credit card can only delay the use of emergency fund and give some breathing space. But credit cards cannot be a replacement for an emergency fund.

It must also be remembered that unless a person has set aside an amount earmarked for emergencies, he will have to dip into his long-term investments for unplanned expenses and that may upset the savings for various financial goals.

Having an emergency fund is a kind of portfolio hygiene factor for everyone. Also, checking the adequateness of emergency fund should be one of the regular points when auditing your personal finance.

(The writer is the founder of StableInvestor.com)