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Go Back to Main Page What are Emergency Funds?

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What are Emergency Funds?

Not all risks in life can be insured. You can insure your life and maybe your valuables as well, but certain events fall outside the scope of insurance. Insurance policies are bound with certain conditions and restrictions, thus leaving several emergency contingencies outside their purview. So, what should an individual do in dire situations where insurance does not protect them? Fret not, as there are certain types of investment options that can help you during a crisis; enter emergency funds.

What is an emergency fund?

An emergency fund is a financial safety net that helps people address financial dilemmas such as unforeseen medical expenses, major repairs to their home or car, loss of job, etc.

Understanding emergency funds

According to most financial planners, an emergency fund must contain enough funds to cover between three to six months’ worth of expenses. You must note that financial institutions don’t carry accounts labelled as emergency funds. Rather, the onus falls on an investor to set up this type of account and designate it as capital reserved for personal financial crises.

Typically, these funds should be held in highly liquid assets such as overnight or liquid mutual funds, savings account, money market instruments, etc. The primary objective of these funds should not be wealth appreciation, but safety and liquidity.

Importance of emergency funds

Having an emergency fund should be a priority for everyone while planning for a financially secured life. Following are some of the reasons why you should have an emergency corpus in place:

  1. Helps to keep your stress levels lowWhen you have an emergency fund, you tend to have a relaxed and stress-free life. This is because you know that you have a back-up plan in place in case things go south or an emergency pops up.
  2. Ensures that you do not redeem from your future savingsYour savings are linked to some very important future goals. An emergency fund helps you to achieve your future dreams by meeting your urgent needs so that you don’t have to tap into your long-term investments.
  3. Ensures that you do not fall into a debt trap
    During financially challenging times, emergency funds can help you stay afloat without having to rely upon loans or credit cards. Emergency funds, thus, ensure that you do not fall into a debt trap during a financial crisis.

Why should emergency funds be liquid?

To cover unexpected expenses, emergency funds must be liquid. One should never put their emergency funds in investment options with a lock-in period as their money can get blocked. One should be able to withdraw the money when they need it without being penalised in the form of exit load or pre-withdrawal penalty. One can keep a part of their emergency funds in a savings account, which can be accessed immediately, and invest the rest in highly liquid options such as overnight funds, liquid funds etc.

How much should your emergency fund have?

Depending upon your income and expenses, the right ‘emergency’ amount depends on your financial position. A good thumb rule states that the ideal amount for your emergency funds should be at least three to six months of your living expenses.  

You can also divide your emergency funds into two categories:

  1. Long-term emergency fundsUnder this category, you save for large-scale emergencies such as sudden medical requirements or a major natural disaster. You can consider investing these funds in instruments that allow you to earn a slightly higher rate of interest but do not take more than a couple of days to liquidate.
  2. Short-term emergency fundsShort-term emergency funds cater to your immediate cash requirements. These funds might offer little in terms of interest but offer high liquidity and accessibility, which can suffice until you gain access to your long-term emergency funds.

Emergency funds calculation

The calculation to know your ideal emergency fund amount is quite easy.

  1. Jot down your monthly income: Your monthly income includes your current salary, secondary income, bonus, investment income, pension (in case you are retired), and other miscellaneous income.
  2. Determine your monthly expensesYour monthly expenses include rent, EMIs (auto/house/personal/educational loan, etc.), utilities, household help wages, groceries, and other miscellaneous expenses.
  3. Determine the monthly amount spent on recreational activitiesThese include dining out, shopping, movies, and miscellaneous activities.
  4. Evaluate the amount spent on travel It includes fuel, public transport, etc.
  5. Calculate the monthly amount spent on your dependants: This includes school/college fees, medical bills, family support, etc.
  6. Jot down other monthly expenses: This includes subscriptions (gym, OTT services, etc.), gifting expenses, insurance premiums, holiday expenses, etc.

Finally, add all your monthly expenses + recreational activites + travel + amount spent on dependants + other monthly expenses and multiply them by six. You now have your calucation to set up the emergency fund.

How to build an emergency fund?

An emergency fund is not built overnight but is rather done gradually. Here are the steps you can follow to build an emergency fund:

  1. Calculate your monthly expensesPre-decide your monthly expenses. Try to control your expenses as much as you can so that you save enough to invest in an emergency fund.
  2. Calculate the total corpus you wish to save: Determine the required corpus to figure out how to add up to your living expenses of at least six months.
  3. Set a monthly savings goal: This will get you into the habit of saving regularly and ensure that the task of creating an emergency fund feels less daunting. One way of doing this is starting an SIP (systematic investment plan).
  4. Assess and adjust contributionsMake sure to check after a few months and evaluate how much you are saving, and adjust if you need to add more funds.

Where to invest an emergency fund?

Once you have finalised the amount for an emergency fund investment and started working towards acquiring that amount, it is important to find a good place to invest the emergency fund corpus.

A savings bank account is a logical choice as it offers high liquidity during a crisis. However, another important feature of emergency funds is that one does not need them regularly. So, rather than investing your entire corpus in a savings account, you can consider investing a part of it in investment securities that offer high liquidity as well as more significant returns than a savings account.

Overnight funds offer reasonable liquidity with potential to earn better returns than a savings account while keeping risks minimal. Invest in a way that offers decent returns without compromising on the liquidity factor. The ideal thing to do is spread your corpus across various investment options such as short-term recurring deposits (RDs), savings accounts, overnight funds, liquid funds, money market instruments, etc.

Redemption of emergency funds

As far as liquidity of emergency funds is considered, liquid funds permit instant redemption of up to Rs. 50,000 or 90% of the invested amount, whichever is lower, per day per scheme. For e.g., if an investor has a balance of Rs. 50,000 in their liquid funds, they can only withdraw up to Rs. 45,000.

One needs to put in a redemption request to make the withdrawal. An investor can opt for the ‘instant redemption facility’ on the fund’s app or website. Make sure to choose the ‘instant redemption facility’, else the money would be transferred the next day. Note that the instant redemption facility is not available offline.

An emergency fund can make a world of difference during crises and help you stay prepared for any financial setbacks. One should view their emergency fund as an insurance policy and guard it carefully. It is not a piggy bank, so you should not use it for incidental expenses.

In fact, as your salary increases and new members get added to your family, make sure to increase the amount to match your new situation. Happy Investing!

Next To Come: Newly Weds Guide To Financial Success