Emergency fund vs health insurance: Which should you prioritise first? Expert explains why you need both

When money is tight, many people face a common personal finance dilemma about if they should build an emergency fund first or spend on health insurance. Financial planners say the two serve different purposes and should not be treated as competing financial goals.

For someone starting with limited savings, the practical approach is to buy adequate health insurance first and build an emergency corpus alongside it, said Anooj Mehta, Partner at 1 Finance.

“The decision for Emergency Fund or Health Insurance is not a choice one should make over another, these go parallel,” Mehta said.

For example, a healthy 35-year-old may pay around ₹12,000- ₹15,000 a year for a ₹10 lakh individual health insurance cover, according to Mehta. The premium, therefore, should be viewed as a relatively small recurring expense rather than something that has to compete with long-term investments.

There is another reason not to postpone health insurance. Insurance protection is time-sensitive because policies typically have waiting periods. Mehta noted that policies can have an initial waiting period of around 30 days, along with longer waiting periods for specified ailments and pre-existing diseases.

How much emergency fund should you build?

The commonly followed six-month emergency fund rule is a useful starting point, but Mehta said people should calculate the corpus based on their committed monthly expenses, rather than their entire spending or income.

These committed expenses can include EMIs, rent, school fees, insurance premiums, utilities, groceries and domestic help. Discretionary expenses can generally be reduced during a financial emergency.

For a household with ₹80,000 in committed monthly expenses, three months of expenses would amount to ₹2.4 lakh and six months would mean an emergency corpus of ₹4.8 lakh.

However, the ideal amount depends on income stability. Single-income households, employees with commission-linked pay and people working in industries with higher layoff risks may need to keep enough money for nine to 12 months of committed expenses. For households with two stable incomes, six months may be sufficient.

Mehta also recommends keeping ₹1 lakh- ₹2 lakh as a separate medical buffer within the broader emergency corpus. Even when a hospitalisation is covered by insurance, policyholders may still have to pay for certain consumables, diagnostics and post-discharge expenses.

“Insurance covers the bill. It doesn’t cover everything on the bill,” he said.

Why savings alone may not be enough for medical emergencies

Relying entirely on savings to fund a major medical expense can create several financial problems.

One risk is having to liquidate investments at an unfavourable time. If ₹8 lakh worth of equity investments are sold during a 20% market downturn, the investor gives up not only the current value but also the future compounding that money could have generated.

There can also be tax implications when investments are sold. Equity-oriented investments may attract capital gains tax, depending on the investment and holding period.

A large medical expense can also derail financial goals. Money earmarked for a home down payment or a child’s education may have to be diverted towards treatment, potentially setting back years of financial planning.

There is another risk that people may overlook. A serious illness can subsequently become a pre-existing condition, potentially affecting the terms or availability of health insurance in the future.

Medical costs can also rise significantly over time. Mehta pointed to medical inflation of around 13%-14% and said a procedure costing ₹5 lakh today could cost roughly ₹17 lakh- ₹18 lakh a decade from now.

When can you stop building the emergency corpus?

An emergency fund can be considered adequately funded once a person has around six months of committed expenses readily accessible, provided the individual’s circumstances support that level.

The money should be kept in relatively liquid instruments such as savings accounts, sweep-in fixed deposits or liquid and overnight funds, rather than equity investments or locked-in products.

But the emergency fund should not be allowed to become a substitute for insurance.

Mehta said the health insurance should be in place and its applicable waiting periods should have been completed. If the person has dependants, adequate term insurance should also be in force.

Once these protections are established, the emergency corpus does not necessarily need to increase every year in absolute terms. Instead, it should be adjusted for rising expenses and reviewed after major life changes such as taking a new EMI, having a child or adding a dependent parent.

Emergency fund and health insurance protect against different risks

The biggest mistake, according to Mehta, is treating health insurance and an emergency fund as substitutes.

An emergency fund is designed to handle frequent, smaller financial disruptions, such as job loss, a temporary income gap or an unexpected repair bill.

Health insurance, on the other hand, protects against low-frequency but high-severity events, such as a major hospitalisation that could otherwise severely damage a household’s finances.

This distinction is particularly important for employees who rely on employer-provided health insurance.

Employer health insurance generally ends when employment ends. This creates a potential vulnerability because a job loss can simultaneously remove both income and employer-sponsored health coverage.

Mehta said people often make the mistake of holding substantial cash savings while relying on a relatively small employer health cover. For instance, someone may have ₹15 lakh in fixed deposits but only ₹5 lakh of employer-provided health insurance.

An emergency fund should provide liquidity, while health insurance should protect the balance sheet from a large medical shock. Neither should be used as a replacement for the other.