Emergency Cash reserves are money kept aside for meeting unforeseen expenses. We are discussing the need to keep cash reserves because; this is one important idea which most of us neglect. When you set aside some money from your earnings to meet unexpected expenses, there are four advantages that automatically come with it:
- Financial safety.
- It allows you to take advantage of a surprise financial opportunity
- It creates a compulsory saving habit.
- Since funds are kept in liquid cash or gold, it earns interest or appreciates in value.
We recommend creating an emergency fund that equals to 4 or 5 months of living expenses; however, you do not need to set aside this total amount in cash alone. It can be in short term fixed deposit or Gold etc.
How much reserve?
That depends from person to person.
There are a number of factors that influences your decision on the quantum of emergency fund that needs to be created. Factors such as age, occupation, health condition, monthly EMIs, number of members in the family, other sources of income needs to be considered on a one to one basis.
Depending upon how old you are, the emergency fund required keeps changing. As you grow older, the possibility of medical emergencies is also high. Hence, if your age is on the higher side (let’s say you’re 45 years old) you also need an emergency fund that’s higher than someone who is just turning 30.
Nature of occupation:
The style of occupation/business you do is another factor that influences emergency fund decisions. If you are doing a seasonal business or if your job has an uncertain future, you need a higher emergency fund. People living on commission based income would also require a high emergency fund.
More reserve funds may be required for a person whose health condition is questionable. The amount of insurance cover he has should also be considered while assessing his future requirement. Higher the insurance, lesser the need for reserve funds on these grounds. Again, if you have your parents or grandparents living with you, you might need to plan accordingly.
The volume of debt you have needs to be analyzed to get an idea about how much EMIs you’ll have to pay a month. Typically, while creating reserve funds, an amount equal to 6 months EMIs should be kept aside so that in case of emergency, you don’t default in your loan payments. A clear track record of loan re-payments is absolutely necessary for your future financial needs.
Number of dependents:
If the numbers of members you need to support are more (say 7 members) naturally you need a higher reserve than what would be required if you have only say, 3 members in your family.
Other sources of income:
You can count on your other sources of income, if any, while creating a reserve fund. One time or casual income or credit card limits should not be considered in this group. However, you can count on the income of your spouse or other family members staying with you in case of emergency.
Other possible expenses:
You may also want to consider other expenses like possible higher education fees for your child who is about to enter college or a possible repair for your house. It all depends from person to person.
How to keep reserve funds?
Hundred percent of your reserve funds need not be kept in liquid cash. A portion of it can be kept in short term fixed deposits or debt funds and a certain portion in gold or easily marketable securities.
Any cash lying idle over and above your emergency fund results in a lost investment opportunity. You are not making your money work efficiently for you.
The thumb rule is – You should have enough reserves to meet all the expenses for 4 or 5 months plus some extra to meet unforeseen expenditure like medical expenses.
How to spot idle funds?
Any fund that remains in your bank account after setting aside your emergency funds is idle funds. To locate whether if you are holding idle funds,
First estimate how much emergency fund you’ll require. (Typically 3-6 months expenses)
Now see how much you have in your bank account plus cash in hand.
Deduct 3 or 6 months emergency fund. The balance is your idle fund.
This fund should be invested immediately. You can take up a systematic investment plan so that an amount gets invested automatically every month; or you can open an online trading account and invest in stocks or mutual funds at your convenience; you can opt to open FD linked savings account so that any balance above a certain limit automatically earns interest at a higher rate and so on.