Emergency Funds – Why have it and where to Invest It

Updated on: Jun 28th, 2022

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5 min read

Preparing for sudden emergencies and securing future finances form the crux of ideal financial planning. We have covered the following in this article:

The Importance of an Emergency Fund

An emergency fund is an essential corpus that you must keep aside to tackle emergencies. It is a fund that you can fall back on at the hour of crisis or for unexpected and unplanned scenarios, and not for meeting your routine expenses. So, you must design it specifically to meet unanticipated financial shortfalls that may apply to you.

Why keep emergency fund liquid

To be in a position to cover unexpected expenses is the reason why an emergency fund should be liquid, it is the most critical feature that you should keep in mind when you are choosing where to park your emergency fund. You should be able to withdraw the money when you need it and with no delay. At the same time, you should ensure that you do not get penalised in the form of an exit load or pre-withdrawal penalty. The value of the amount invested should not go down either and must deliver excellent returns.

How to Build an Emergency Fund

An emergency fund cannot be built overnight but is done gradually. Set aside a particular amount every month in a different bank account. Soon it will grow into a considerable corpus that you wish to have. Say, you have decided to have an emergency fund of Rs.1 lakh. In this case, you can set aside Rs.5,000 or Rs.10,000 every month to accumulate the corpus you need. It is fine to even cut down on your investments to build this amount.  

How much should your Emergency Fund have?

Depending on your income and expenses, an emergency fund can be three to six months of your monthly income. For example, if you earn Rs.30,000 a month and Rs.15,000 of that goes in meeting your routine living expenses, then your emergency fund should be somewhere in the range of Rs.60,000 to Rs.1,00,000.

You may even choose to divide your emergency fund into 2 categories.

Long-term emergency funds

This is where you save for large-scale emergencies like a major natural disaster or a sudden medical emergency. This fund should be invested in instruments that allow you to earn a slightly higher rate of interest but may take a couple of days to liquidate.

Short-term emergency funds

This is the fund you rush to in cases of emergencies. Such a fund should offer little in terms of interest but allow immediate accessibility, which in case of extreme situations can suffice till you gain access to your long-term emergency funds.

Where to Invest in an Emergency Fund

Once you have accumulated the emergency fund, you shouldn’t leave it in cash or the bank account, at least not entirely. Even though an emergency fund should be liquid, it is not something you can access often. Hence, invest it in a manner that you earn decent returns from it without compromising on liquidity. The ideal thing to do would be to spread the emergency fund across liquid funds, short-term RDs and debt mutual funds.  

Example:

Suppose you have your Rs.1 lakh accumulated as your emergency fund. What you can now do is keep Rs.20,000 in cash at home, let Rs.20,000 stay in your savings bank account and invest the remaining Rs.60,000 in a liquid mutual fund.

Note:

A liquid fund is a class of debt funds that invests in debt instruments of less than 91 days maturity. These debt instruments are high-rated papers and are not affected by interest rates. Hence, they earn decent returns without being volatile. Over the past years, liquid funds have earned returns of up to 8%. These are higher returns than what you would get from a savings account or fixed deposits. If you happen not to need this emergency fund and stay invested in the liquid fund for over three years, then you will even benefit from indexation when you eventually redeem.  

Redemption of emergency funds

As far as liquidity is concerned, many liquid funds allow instant redemption of up to Rs.50,000 or 90% of the invested amount. You can redeem any time. They will credit the money to your linked bank account instantly. Check for this instant redemption facility before you invest in a liquid fund to make sure the fund house allows it. This way, by spreading your emergency fund across different avenues, you can ensure quick accessibility while enjoying high returns.

In a nutshell, be prepared for the uncertainties of tomorrow. Let ClearTax guide you in building your emergency fund.    

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Quick Summary

Proper financial planning includes preparing for emergencies by having an emergency fund. This fund should be easily accessible, gradually built, and ideally 3-6 months of your income. It can be divided into short-term and long-term funds, invested in liquid funds, short-term RDs, and debt mutual funds for liquidity and returns. Spreading the fund across different avenues helps ensure easy access and potential growth.

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