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. So, you must design it specifically to meet unexpected financial shortfalls that may apply to you.
2. Why keep emergency fund liquid
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. At the same time, you should ensure that you do not get penalized in the form of an exit load or pre-withdrawal penalty fee. The value of the amount invested should not go down either and must deliver guaranteed returns.
3. How to Build an Emergency Fund
You cannot build an emergency fund overnight, but you should do it gradually. Set aside a particular amount every month in a different bank account. Soon it will grow into a suitable emergency fund that you wish to keep.
Say, you have decided to have an emergency fund of ₹1 lakh. In this case, you can put aside ₹5,000 or ₹10,000 every month before you accumulate the corpus you need. It is OK to even cut down on your investments to build this amount.
4. 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 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.
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. You can redeem any time through the fund house’s website or app. 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 great returns.
In a nutshell, be prepared for the uncertainties of tomorrow. Let ClearTax guide you in building your emergency fund.