While it might be impossible to avoid the various emergencies that might come up, you can plan ahead and be prepared to meet such situations head on. That’s why, the importance of emergency financial preparedness cannot be overstated. Let’s take a closer at the different aspects of how you can ensure adequate emergency fund planning to overcome a wide range of financial emergencies.
5 Key Reasons to Ensure Emergency Financial Preparedness
The key goal of ensuring adequate financial preparedness for emergencies is to ensure that you can overcome unexpected situations with minimal effort. While there are different ways to do this, the 5 key reasons to ensure financial preparedness for various emergencies include:
- Helps Sustain Your Current Lifestyle
In an emergency, your finances might get stretched or you might lose access your regular income from business, profession or salary for a while. Some emergencies that can lead to such a situation include an unexpected job loss, a long illness that leaves you unable to work, diagnosis and treatment of a critical illness such as cancer, etc. If you plan adequately for such eventualities, you will have sufficient finances handy to handle these emergencies without having to compromise your basic financial needs and lifestyle. - Limits Dependence on High Interest Debt
In order to overcome a financial emergency, one common method that many resort to is to borrow money such as through a personal loan or by opting for credit card debt. These types of debts have significantly high interest rates and if not handled efficiently, even lead to falling into a debt trap. If you are adequately prepared with alternative sources of finance, you would be ideally placed to eliminate the need or reduce your dependence on such high interest debt. This can help protect your finances in the long term. - Protect Long Term Wealth Goals
In order to achieve various long terms goals, you would have to invest in instruments that grow through the power of compounding. So, premature withdrawals in an emergency can adversely impact your ability to reach your long-term financial goals. Being prepared for emergencies ensures that the need for such premature withdrawals is eliminated or minimised. This will help you stay on track to reach to your long-term financial goals. - Manage Medical Emergencies
One key aspect for ensuring emergency financial preparedness is to be prepared for health emergencies. Medical emergencies whether minor or major can lead to severe financial stress unless you are adequately prepared. This is why purchasing insurance and adequate emergency fund planning are essential to make sure you are adequately prepared to manage various medical exigencies with minimal impact. - Reduce Mental Stress
Emergencies often can come as a surprise and can lead to significant mental stress. Addition of financial stress on top of this can only compound the overall stress that you have to deal with. So, while the initial stress of combating the unexpected situation cannot be eliminated, adequate emergency fund planning can at least relieve the stress that might be caused by financial distress in case of an emergency. - Helps Post-Emergency Recovery
The assets you might possess might be impacted by disasters or prone to various risks such as theft or pilferage. Adequate preparation to manage such eventualities can help in post-emergency recovery. This can be achieved in various ways such as purchasing insurance to protect your existing assets from various risks as well as through various measures that ensure emergency financial preparedness.
How to Prepare Yourself for Financial Emergencies?
In order to manage various financial emergencies, you should consider 3 key options. These are - creating an emergency fund corpus, purchasing protection plans and purchasing insurance plans that can protect against potential risks to your assets or livelihood. Let’s consider these options in greater detail, so that you can plan ahead and be adequately prepared to deal with a wide range of financial emergencies.
Create an Emergency Fund
An emergency fund is perhaps the single most important financial safety net that you can create. An emergency fund, as the name suggests, is designed to provide financial support to meet a variety of financial emergencies that might happen unexpectedly. Some key aspects to consider when creating an emergency fund include the following:
- Size of the Emergency Fund Corpus
The primary factor to consider when determining the size of your emergency fund is your monthly expenses. In order to adequately understand your monthly expenses, you need to consider all your fixed and variable expenses on a monthly basis.
Examples of fixed expenses are rent,loan EMIs, insurance premiums, money paid for various subscriptions such as cable TV, Internet, Magazines, OTT, etc. These expenses usually stay constant so, do not change significantly over time and there is often less scope to reduce these costs easily.
On the other hand, variable costs are often linked to an individual’s lifestyle and are liable to change depending on multiple factors such as weather conditions, festive season, etc. Examples might include purchase of a new phone, an overseas trip, monthly electricity bill, cost of purchasing gifts for festivals, etc. In most cases, these variable expenses offer the greatest chance to decrease your expenses.
As a general rule, the size of an emergency fund corpus is typically pegged to the fixed costs of an individual’s budget. Experts suggest that the minimum size of an emergency fund corpus to ensure adequate emergency financial preparedness should be between 6 months’ to 9 months’ expenses. So, if the fixed cost portion of your monthly budget is ₹50,000. You should consider maintaining an emergency fund corpus of at least ₹3 lakh to ₹4.5 lakh.
- Ideal Instruments for Maintaining an Emergency Fund Corpus
One common question that often comes up with respect to an emergency fund is which instruments should the corpus be maintained in. When maintaining an emergency corpus, potential long term returns are not the goal of these investments. You should instead focus on ensuring that these funds are at minimal risk and they are highly liquid to facilitate easy availability in an emergency.
A few instruments that fit these 2 criteria of high liquidity and low risk include - liquid funds, ultra short duration funds, short-term FDs, money market funds and savings account.
Consider maintaining at least 40-50% of your emergency funds in a savings account from a scheduled bank or a high yield savings account such as those offered by small finance banks.These deposits are highly liquid and as the risk is low as these deposits as well as bank FDs are insured up to 5 lakh per depositor per bank by DGCGC, a government backed body.
Similarly, liquid funds, money market funds, and ultra short duration funds are also considered to be relatively low risk savings plans that can be easily converted to cash in an emergency. However, being market-linked instruments, these do not offer assured returns like FDs or savings accounts.
- When to Use Emergency Funds
Once you have created a designated emergency fund, be very clear about what actually constitutes an emergency. Unless you make a conscious effort to restrict deployment of an emergency fund to specific situations,your corpus might get depleted even though an actual emergency hasn’t occurred. This would defeat the primary reason for creating the emergency fund. So ensure that you clearly define what constitutes a financial emergency so that this corpus is only used for its intended purpose.
Purchase Adequate Protection
When it come to managing risk, there is often no alternative to purchasing insurance policies. You can opt for various types of insurance plans that can help you manage various types of risk. Key types of insurance that you should consider purchasing include:
- Life Insurance Plans
Term insurance plans are perhaps the most popular type of life insurance plan in India. Term plans are affordable pure risk plans that are specifically designed to provide a financial safety net to your loved ones in case of your demise.Other types of life insurance plans that can fulfill the needs of different groups of individuals include ULIP policies, endowment plans, whole life plans, etc.
- Health Insurance Plans
Healthcare costs in India have witnessed a steep increase in recent years. So a medical emergency can strain your finances significantly and even wipe out your savings unless you are adequately prepared. One way to ensure that you are well-prepared to deal with any future health emergencies is to purchase a comprehensive health insurance plan.
Health insurance plans ensure that if you have to seek treatment or undergo hospitalisation due to any covered conditions, your out of pocket expenses are minimised or completely eliminated. This ensures that your savings are not depleted immediately in the case of a health emergency.
You should also consider augmenting your health plan with optional add-ons available with various life insurance plans. Examples of such plans include terminal illness and critical illness riders. These provide a lump sum payout to the policyholder, if the life insured is diagnosed with a terminal or critical illness.
- Insurance to Protect Assets
During you lifetime, you might purchase or build different types of assets such as residential/commercial property, cars, movable assets such as paintings,physical gold, various collectors items,etc. In order to protect such assets from potential damage, theft or other forms of losses, you need to consider purchasing insurance.
Some types of insurances that can help protect such assets or your livelihood from different types of risk include fire insurance, home insurance, flood insurance, automobile insurance, malpractice insurance, etc. These are designed to protect against a variety of emergencies that might threaten the use or availability assets or even your livelihood. This way, you can manage additional risks and be prepared against a range of financial emergencies.
Concluding Thoughts
Even if you make the best plans and implement them, there is always the possibility, no matter how small, that an emergency might occurs that is beyond your ability to manage with ease. In such a situation, you need to ensure you have sufficient mental resilience to face the situation and solve the problem at hand with a clear mind. But even then, planning ahead by ensuring emergency financial preparedness can give you a head start towards finding a solution to the problem that might otherwise be considered unsolvable.
