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One of the prime principals to good financial planning is being prepared for the future, hence, it is an absolutely essential element of a solid financial plan to have provisions for an emergency fund which is designed specifically to meet unexpected financial shortfalls.

  1. The importance of an emergency fund
  2. How to build an emergency fund?
  3. How much should your emergency fund have?
  4. Where to invest an emergency fund?
  5. Redemption of emergency funds

 

1. The Importance of an Emergency Fund

An emergency fund is essentially an amount of money that you keep aside for emergencies. It is a fund that you can access at the hour of crisis or for unexpected and unplanned scenarios, and not for meeting your routine expenses.

 

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It is for this reason that an emergency fund should be liquid. This 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 without any delay, and at the same time, you should ensure that you do not get penalized in the form of an exit load when you access this money. It should not go down in value while it is invested either. It must, therefore, offer guaranteed investments and be reliable.
 

2. How to Build an Emergency Fund

An emergency fund should be given priority over investments as well. You will not be able to build an emergency fund overnight, but you should do it gradually. Set aside a particular amount every month in a different bank account before you have the entire emergency fund that you wish to keep.

Let’s say you have decided to have an emergency fund of ₹1 lakh. In this case, you should put aside ₹5,000 or ₹10,000 every month before you accumulate the corpus you need. You can even cut down on your investments to build this amount.

 

emergency fund
 

3. How much should your Emergency Fund have?

Depending on your income and expenses, an emergency fund can be 3 to 6 months of your monthly income. For example, if you earn ₹30,000 a month and ₹15,000 of that goes in meeting your routine living expenses, then your emergency fund should be something in between ₹60,000 to ₹1,00,000.

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

a. Long-term emergency funds  

This is where you save for large-scale emergencies like a major natural disaster or a sudden medical emergency. This option allows you to earn a slightly higher rate of interest but may take a couple days to liquidate.

b. Short-term emergency funds

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

4. Where to Invest in an Emergency Fund

Once you have accumulated the emergency fund, you shouldn’t leave it in cash or in the bank account, at least not entirely. Even though an emergency fund should be liquid, it is not something you will be accessing often. Hence, it should be invested 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 cash, bank account, and debt mutual funds.

 

Example:

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

 

Note: A liquid fund is a type of debt mutual fund that invests in debt instruments of less than 91 days maturity. These debt instruments are high-quality papers and are not affected by interest rates. Hence, they earn decent returns without being volatile. Over the past 1-year, 3-year and 5-year periods, liquid funds have earned returns of 6.57%, 7.66% and 8.14% (as on 4 September 2017). These are higher returns than what you would get from a savings account or from fixed deposits. If you happen to not need this emergency fund and stay invested in the liquid fund for over 3 years, you will even benefit from indexation when you eventually redeem.
 

5. Redemption of emergency funds

As far as liquidity is concerned, many liquid funds allow instant redemption of up to ₹50,000 or 90% of the invested amount. The redemptions can be done any time using the fund house’s website or app and the money gets credited 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 cash, savings account, and a liquid fund, you can ensure accessibility any time you want and also earn decent returns while the money is left unused.

Better safe than sorry: Be prepared for the uncertainties of tomorrow; let ClearTax guide you in building your emergency fund.

 

 

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