Investor question: “Hey, I just got a hike this year. You guys say an emergency fund should have 4 months of salary or six months of expenses. Should I bump up my emergency fund?”
Answer: Yes. You should, in fact, increase your emergency fund amount to reflect your new income. Here’s why.
Your emergency fund is your first defence against uncertainty. The idea is that any potential loss of income or sudden unexpected need can be handled without you running helter-skelter and asking relatives or borrowing at exorbitant rates. An emergency fund keeps things running as they should till the “emergency” is over.
Now let’s consider what happens when your income goes up.
As your income goes up, generally so do your expenses as well as investment allocation to your various life goals. You might also, due to the increase, decide to go for financial goals which you couldn’t really afford earlier.
Your emergency fund is your first defence against uncertainty.
What all this means is that your earlier emergency fund amount may be insufficient considering your new reality. If you need Rs 50,000 each month to live on now, after the raise and finance your objectives as well, then an emergency fund that was designed for Rs 40,000 a month will be insufficient.
So if your income has gone up, bump up your emergency fund too.