You cannot predict emergencies and the financial burden attached to them. And that is why it is advisable to have an emergency fund to fight any crisis.
Defining an emergency fund
An emergency fund lets you cater to the financial requirements of an emergency. Individuals with an emergency fund don’t need to rush for unplanned loans, over utilize their credit cards, or sell and mortgage existing assets.
To determine the quantum of emergency fund required, you need to consider your obligatory expenses. Generally, obligatory expenses are EMIs, rent, school fees, insurance premiums, food and medical bills, basic repairs and maintenance, and whatever you feel is unavoidable.
There is no standard definition or list for obligatory expenses. For instance, paying for domestic help and chauffeur or gym memberships qualifies as necessary for some, and luxury for others. As a golden rule, you need to set aside sufficient money in your emergency fund to meet your obligatory expenses.
How important is an emergency fund?
Meeting foreseeable expenses is easy. But, when you have unplanned expenses, an emergency fund helps you manage them efficiently. The ongoing pandemic is an example of situations that demand unexpected expenses. Individuals with an emergency fund will be in a much better position to manage their expenses during the lockdown than those who don’t.
In a nutshell, when times are financially challenging, an emergency fund ensures that you stay afloat without exhausting credit card limits or seeking loans.
Where should you park your emergency fund?
After you decide the size of your emergency fund, the next step is to start building it. This not only includes saving the funds, but also finding a good place for investing the funds. Here are some options that you could explore:
- Cash
While many people discourage cash, it is the only option in several emergencies. Some natural disasters like fire, storm, curfew, landslides, etc., impact internet services, thereby restricting the digital payment options. Thus, you can keep some cash at home to meet expenses for 7 to 10 days. However, make sure you invest the remaining funds in the right products.
- Savings account
A savings account is a good choice since it offers liquidity. Having funds available instantly is vital during an emergency. You must choose a savings account with a high-interest rate and no minimum balance requirements. The fees for maintenance of the account should also not be heavy.
Another factor to remember about emergency funds is that you do not require them regularly. Thus, instead of opting for the returns on a savings account, you can choose to invest a portion of this fund in schemes with high liquidity and better returns than savings accounts.
- Liquid mutual funds
Seasoned investors plan their emergency fund and keep a part of it in liquid mutual funds. These funds are safer than other debt investments. Moreover, their returns are higher than savings bank accounts. However, please note that it takes a couple of days to redeem these funds. The average returns you can expect to earn on liquid mutual funds are between 6% to 8%.
- Debt mutual funds
Remember that you need to build an emergency fund. If your basic monthly expenses are ₹30,000, you need to set aside a minimum of ₹2 lakh. Keeping inflation and rising cost of living in mind, saving this amount can take time. Debt mutual funds are smart instruments that can help you reach your goal faster.
Debt mutual funds allow you to earn good returns while keeping the risk low. With the help of these funds, you can create the corpus quicker. Also, when you receive your annual bonus, you can invest it in these funds to reach your target sooner.
- Sweep-in FDs
Fixed deposits offer better interest rates than savings accounts. Moreover, the funds are liquid since you can withdraw them on the same day by visiting a bank branch during operating hours. If you create the fixed deposit online, you can liquidate it online, even on a bank holiday.
For offline FDs as well, you can apply for a sweep-in facility. This facility lets you break the FD and withdraw funds even on holidays.
Final thoughts
The objective of an emergency fund is to serve as your parachute during the freefall of a financial crisis. Therefore, you may not want to take it lightly. You must review your emergency fund requirements once every year and take action to have sufficient funds for meeting unplanned expenses accordingly.