We all learnt the importance of having an emergency fund in the year 2020 due to unprecedented developments. If you don’t know what an emergency fund is, then here it is- it is a corpus accumulated exclusively to cover unavoidable expenses arising due to an emergency or crisis such as ill-health, job loss, and so on.
An emergency fund should be utilised exclusively to cover emergencies. You must not access this fund to cover your regular expenses. Now, the question is- how much should you accumulate under your emergency corpus? It depends on your lifestyle and financial commitments.
Ideally, your emergency fund should be sufficient to cover your family’s expenses for six months. For instance, if your monthly expenditure is Rs 30,000, your emergency corpus should be Rs 1,80,000. You have to ensure that you rebuild your emergency corpus as soon as you have accessed it.
How to build an emergency fund?
If you don’t have an emergency fund yet, you have to adopt the rule of 50:30:20 in your finances. The rule says that you have to utilize 50% of your monthly income towards needs such as home rent/EMI, groceries and utilities. In simple terms, needs are those expenses that have to be made to sustain your lifestyle.
30% of your monthly income should be used to cover wants such as gym membership, new clothing, dining out, vacation, and other subscriptions. Wants are those expenses that could be avoided, but being made to make your life comfortable. The remaining 20% of your income should be saved.
The amount you save by adopting the rule of 50:30:20 should be first utilised to build an emergency fund. Once your emergency fund has grown to the extent that it could cover expenses for six months, you can start investing the 20% of your income that you are saving as per the rule.
It would be best to look for ways to maximize your savings by cutting down on unnecessary expenses so that you can build your emergency fund soon. Since an emergency fund should be readily accessible by you, it should necessarily be built in a liquid instrument which allows instant withdrawal.
Where should you accumulate your emergency fund?
As mentioned above, you must be able to access your emergency fund readily. It makes it essential that you choose to invest in only those options that facilitate instant withdrawals with minimal to zero penalties. Investments such as Public Provident Fund are not an option. So, where should you invest? Here are the options:
i) Liquid funds
Liquid funds are a class of debt mutual funds whose asset allocation is made mostly towards high-rated (AA and above) debt and money market instruments that mature within 91 days. The short maturity period of the underlying securities makes liquid funds less vulnerable to interest rate movements.
Liquid funds do not come with a lock-in period, and the redemption of these fund units is processed within two working days. Also, there are no exit loads levied on redemption if you redeem your holding after seven days from the investment date. These funds have the potential to provide nearly twice the returns as compared to a regular saving account.
ii) Overnight funds
Overnight funds are a type of debt funds that invest in fixed-income securities whose residual maturity period is one day. Since these funds’ underlying securities mature in a concise duration, it makes overnight funds less sensitive to interest movements.
These funds invest in collateralised borrowing and lending obligation (CBLO), reverse repo, cash equivalent and other high-rated debt securities that mature in a day. These funds have almost zero credit and interest rate risks. Therefore, investing in overnight funds is an excellent way of building an emergency corpus. These funds may offer slightly higher returns than a savings account.
iii) Regular savings account
Parking your money in a regular savings account is also an option to accumulate your emergency corpus. However, you have to ensure that you don’t access it unknowingly. To avoid such instances, it is advisable to have separate savings accounts exclusively to deposit a fixed sum at regular intervals to build an emergency fund.
The main advantage of accumulating your emergency fund in a saving account is that you can access it through various modes such as internet banking, ATM, and cheque. However, the only drawback is that you compromise on the returns you earn as these accounts are currently returning in the range of 2% to 4%.
iv) Bank deposits
If you are not willing to invest in mutual funds and not happy with the meagre returns offered by a regular savings account, then you may consider investing in a recurring deposit (RD). In an RD, you invest a fixed among every month and earn higher interest than a regular savings account.
If you have accumulated a lump sum and would like to have it as your emergency corpus, you may invest that amount in a bank fixed deposit. These deposits are made for a fixed tenure, and you earn interest at a predetermined rate. Some banks may levy penalty in the form of reduced interest upon premature withdrawal.
Gold is one of the traditional investment options in India. If you want your emergency fund in a tangible form, you may consider investing in physical gold. However, you must stay away from jewellery and ornaments as they come with making and wastage charges and you may suffer a loss if you are to sell it. Instead, you may invest in gold coins and bars. Physical gold is highly liquid in the market, and you can exchange it for cash in little to no time. Also, if you have gold jewellery, then you can pawn them during a financial crisis.
Having an emergency fund covering six months of your expenses is essential. You may consider accumulating your corpus in any of the options or a combination of the options mentioned above. It is imperative to stay financially disciplined at least until you have a sizable emergency fund to fall back on during a financial crisis. Once you have your emergency corpus, you may then start investing to achieve your financial goals.
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Engineer by qualification, financial writer by choice. I am always open to learning new things.