Here's why saving for emergency is important

Priyansh was earning a healthy pay check, owned a luxurious home in an uptown community, a brand new car parked at his door, branded clothes, eating out in good restaurants - life could not have been better.

As luck would have it, the economy took a downturn and he was laid off from work. He also had to face huge losses in the stock market.

To add to his misery Priyansh's father had to be hospitalized and the expenses for his medical treatments were exorbitant - his happy family picture vanished in no time. Not only did he go through an emotional upheaval but also was in deep financial crisis.

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The EMIs on the home loan and car loan started becoming a burden and soon he started defaulting payments.

The heap of unpaid medical bills also kept increasing with time.

Why did a well educated man, earning so well, face such a situation? Couple of reasons - a lavish lifestyle with little emphasis on savings, lack of insurance, impulsive investments and the most important reason was that Priyansh had not kept aside an emergency fund.

As the name suggests, an emergency fund is money that can be used in cases of financial emergencies.

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It could be a single large expense like a sudden illness or loss of job or it could be a simple expense such as a broken pipeline expense, car repairs, etc.

How much should you invest in an emergency fund?

The quantum of your emergency fund depends upon your lifestyle, ability to save, your stage in life and your financial obligations.

For a bachelor in his early 20s, just joining the employment scene, with no family responsibilities and no debt obligations, the purpose of an emergency fund would be pretty simple like taking care of living expenses if he is out of job for a while.

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Hence the emergency fund could be about six pay checks in value or rather living expenses for a period of six months, including obligations like LIC payment, insurance payment, etc.

On the other hand, if a person has a home loan and a family to support, his emergency fund should take care of his living expenses, financial obligations like LIC payments, plus the EMIs on the home loan for a period of six months at least.

It is also a good idea to have a component for medical expenses in your emergency fund in the event of an accident or sudden hospitalization, in case your company does not provide health insurance and you have not purchased one for yourself or your family members.

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You need not transfer a lump sum into the emergency fund account. Small but consistent deposits will not put pressure on your current spending and also build a reasonable fund over a period of time.

If you think you do not have extra funds, find ways of cutting expenses and divert these funds into an emergency fund.

For example, use your bonus to invest in an emergency fund, skip going to a restaurant or a movie night at the theatre. These small sacrifices will help you build a good emergency fund over time.

You should be able to instantly withdraw money from your emergency fund hence it should have liquidity.

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At the same time, keeping the money idle is not practical - even your emergency fund money should grow.

However, invest in a completely safe avenue - even if it earns lower returns. Remember the primary objective of the fund is to protect you on a rainy day.

i) A savings account is the best place to keep your emergency fund. Most savings accounts have the auto sweep facility between savings and fixed deposits. Invest in such a savings account as you will earn a better interest rate.

ii) Short-term deposits are also a good investment avenue for an emergency fund.

iii) Gold also is a traditional form of emergency fund. Buy 24 karat gold coins especially to meet emergency cash needs.

iv) A credit card can also be used as an emergency fund. However, use it as your last option and only if you plan to repay the dues within the interest free period, as interest rates are the highest on a credit card.