You get your salary at the end of the month. You use the amount to pay your bills and EMIs, make investments and take care of other regular expenses. You do this month after month. It is well-oiled machinery. Your expenses fit in your budget. Everything is hunky-dory. What will you do if this machinery were to develop any glitches? Your income goes down due to loss of job and pay cuts. You cannot work because of an illness or due to a hospitalisation. You might have to incur an unplanned expense towards meeting a medical emergency. What do you do? How will you pay your rent or loan EMIs? A contingency fund or an emergency corpus can come in handy at such times.
EMERGENCY CORPUS ONLY FOR SHORT TERM ISSUES
Medical Emergency (Illness / Injury / Hospitalisation / Surgery)
No Work / Loss of Pay
LONG TERM / PERMANENT ISSUES
Buy insurance for permanent disability
Reduce expenses during economic slowdown
In this post, I will focus only on short term or temporary glitches in the machinery such as illness, minor injury or surgery. Contingency fund and medical emergency fund can be useful only in these short term problems. For permanent or long term issues such as permanent disability, you will have to purchase disability insurance from insurance companies. In case of economic slowdown (and your income suffering because of that), you will need a relook at your expense pattern. I could have merged contingency fund and medical fund. However, I prefer to keep these two separate. It is a personal choice.
Here are a few points to consider when it comes to contingency fund or medical emergency fund.
Employee vs. Self-Employed
If you have a stable job in organised sector, it is not uncommon to get a paid medical leave for a few months. In case, you were to fall sick, undergo a surgery and get injured, you will get your salary for a few months without joining work. This is a significant advantage employees have over self-employed or the ones running their own business. Do note this may not happen in all cases. You must go through terms and conditions of your employment before jumping to any conclusion. Even if you are a salaried employee, your employer will not cover you for eternity.
If you are self-employed, your ability to earn income may be severely compromised if you are not able to join work for any reason (unless you have been able to build contingency in your business). And this may come at a time when your expenses have gone up (say, towards medical expenses).
Single Income vs. Dual Income Household
The chances of both the members losing job at the same time are much lower. Even if the income of one of the members were to get compromised due to a reason, the other person can provide temporary relief. Hence, dual income households can do with a slightly lesser emergency corpus than a single income household.
What Is an Adequate Emergency Corpus?
There is no fixed answer. The requirement will vary. Expense for 4-6 months looks a reasonable number to me. You will have to review your specific situation and take a call. In specific cases, the number may even be higher. Requirement for a self-employed professional may be higher than a salaried employee. Dual income household may do with a lesser corpus than a single income household.
A salaried employee also needs to consider how easy or difficult will it be to find a new job (given the skill set and the industry you work in). Lesser confidence you have, the bigger corpus you need. Self-employed professionals need to assess the business outlook honestly and take a call.
About size of medical fund, consider your family’s medical history and cost of treatment at your preferred hospitals. Again, there is no fixed answer.
I Have Health Insurance. Do I Still Need a Medical Emergency Corpus?
Yes, you do. Murphy’s Law can strike any time. For some reason, insurance company can decline to pay the bills. In some cases, you may have to pay the bill first and then apply for reimbursement. You will have to pay first and claim later. Medical fund will be handy in such cases. You may have better clarity when you go for cashless treatment but that works well only in case of planned hospitalisation. Even with cashless hospitalisation, in cases of emergency, you will have to first make an initial payment to the hospital and then inform the insurance company. And don’t forget insurance companies do not pay for everything. The cost for consumables will have to be borne by you. If your health cover has co-payment clause and sub-limits, your medical fund requirement just got bigger. There may also be instances where, you or any family member, may not be able to purchase medical cover. In such cases, you need a higher medical fund.
Where do I keep the Emergency funds?
KEEP EMERGENCY FUNDS IN
Savings Bank Account
Liquid Funds or Short Term Debt Funds
Savings Bank Account. Money in the savings account is always readily available. Hence, it fits the purpose the best. However, the return is quite low at 4% p.a. Moreover, credit cards are now acceptable almost everywhere. So, you can always swipe your card and pay the bills later. Hence, the need for ready money in the savings bank account may not be as high.
Fixed Deposits. Fixed deposit is also a good option. The only issue is that interest income is taxable. Additionally, in case of premature withdrawal or breaking of FD, there is an interest rate penalty.
Liquid funds or short term debt funds. Given the nature of requirement, you never know when you might need the funds. You may not touch the corpus for years together. In such a case, liquid funds or ultra short term funds may provide better flexibility and tax efficient returns. The capital gains tax liability arises only at the time of redemption of MF units. So, if you happen not to use the funds for more than 3 years, the capital gains will only be taxed at 20% after indexation.
Keep a small amount in savings bank account and the remaining in liquid funds or ultra-short term debt funds. You can do the same for medical emergency fund.
Contingency Fund and Medical Emergency Fund Need to Be Replenished
An emergency can strike again. And you need to be prepared. For instance, if you managed to accumulate adequate medical fund but had to use it for medical treatment of a family member, you must replenish the fund so that you can use it the next time. Do the same for contingency fund.
Resist the Temptation
You want to go for a vacation and you have funds lying in a liquid fund earmarked for emergencies. You might feel tempted to use the emergency funds for a vacation or purchase of a car. Resist such temptation. Do not touch emergency funds for any other purpose. Firstly, you may not be able to accumulate the corpus again easily. Secondly, an emergency can strike anytime. What to do if you need emergency funds just after purchase of a car or during vacation.
Financial planning is not just about planning for the expected. It is about planning for the unexpected too. Having a Contingency fund and medical emergency fund is about the latter. In absence of such measures, in the event of an emergency, you may have to dip into savings earmarked for other goals such as retirement. Hence, not planning for unexpected events may compromise your planning for the expected events.