The dictionary definition of “emergency” is “a sudden unforeseen crisis that requires immediate action.” Emergencies can be of different types and the best way to handle them is by staying prepared for them. Of course, there is not much you can do to prepare for natural emergencies, but to meet financial emergencies, it always makes sense to have an emergency fund.
The importance of an emergency fund
An emergency fund is essentially an amount of money that you keep aside for emergencies. This is money that you touch only on rainy days and don’t use for your routine expenses.
An emergency fund should be used in case you’ve lost a job or source of income that you and your family were dependant on. Other reasons to use an emergency fund would be a critical medical situation or family crisis. Basically, an emergency fund is money you can access in the middle of the night.
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, you should not be penalised in the form of an exit load when you access this money and it should not go down in value while it is invested.
How much to have in your emergency fund
Since an emergency can strike any time and you cannot tell for how long it will last, you should have a sizeable emergency fund. If for some reason you are unable to go to work, your income stream would come to a halt during this period. This is when an emergency fund would come in handy. Similarly, if something happens and you need money in a matter of minutes, you can dip into the emergency fund. To be able to get you out of any such situation, an emergency fund should be a decent amount.
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.
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.
Remember that your regular mutual fund investments or fixed deposits cannot count as an emergency fund as they are not always liquid. You will not be able to access this money in the middle of the night. Your investments should follow your goals, while your emergency fund should be kept separately.
Where to invest 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.
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.
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 that what you would get from a savings account or 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.
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 does allow 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.