We all know that life is quite uncertain and we never know what the future may hold for us. So, it is always best to be ready. Any uncertainty in the lifespan of the breadwinner or even in the case of a dependent disturbs the life as well as the finances of the entire family. To avoid such an uncertainty in life, you need an emergency fund so that you are always prepared to handle what life throws at you – good or bad.
What is an emergency fund?
An emergency fund, also called a contingency fund, is an amount you keep aside for emergencies. It is created to manage unforeseen financial needs, such as those arising from a job loss or salary cuts, medical emergencies not covered by insurance, unexpected travel expenses, etc.
Suppose someone encounters an unexpected event like they get laid off. Even though they might have some money in their bank account, it may not suffice if it takes them time to find a new job. They will need money to cover expenses and pay EMIs during this period.
Many more unexpected events such as this come down the road and can adversely affect us financially unless we have separate funds to manage them. In spite of this, more often than not, many people and families fail to build an emergency fund. But, in reality, this is the first and the foremost step while creating financial goals for an individual. So, we all should start planning for it even before we think about any other financial goals.
How much should my emergency fund be?
The answer depends on your age and monthly expenses but a good rule of thumb is to have enough to cover six to nine months’ expenses. For example, if you earn ₹50,000 monthly and ₹35,000 of that goes into meeting all your expenses, then your emergency fund should be something between ₹2,10,000 to ₹3,15,000 (₹35,000 multiplied by six or nine).
One important thing to remember while calculating your monthly expenses is to consider EMIs and insurance premiums that need to be paid.
| How to Calculate Emergency Fund? |
|---|
| Monthly expences (Rent + Food + Clothing + Children School Fees + EMIs + Mis)* 6 Months = Emergency Funds |
This can feel like a huge number, especially if you’re starting from scratch, but it is not really that difficult to put together. The important thing is to start putting some money aside every month.
How to build an emergency fund?
Since your emergency funds need to be invested in minimal-risk instruments, you have multiple options – your savings account, recurring deposit (RD), fixed deposit (FD), debt mutual funds such as an ultra short-duration fund or liquid funds.
- Savings account: If you choose to use your bank savings account to maintain emergency funds, you need to ensure that you are disciplined enough not to withdraw and spend your money except in the case of an emergency. This is difficult unless you have a separate bank account to park your emergency funds.
- Recurring deposits: Alternatively, using a recurring bank deposit (RD) to save emergency funds will give you slightly higher returns, 4% to 8% p.a. However, if you withdraw your recurring-deposit investments prematurely, you will have to pay the penalty, which can decrease your overall returns from the investment. Plus, the interest from bank RDs is fully taxable as per your income-tax slab.
- Fixed deposits: You can earmark an existing FD as your emergency fund, or if you already have a lump sum, you can invest it in an FD. You can earn higher returns this way based on the FD tenure but do remember that FD returns are taxable as per your tax slab. Plus, if you prematurely break an FD, that could entail some penalty as well.
- Liquid funds: Liquid funds are the best way to build an emergency fund. These debt funds invest in bonds with maturities up to 91 days. Liquid funds are low-risk, and at the same time, you get a chance to earn higher returns than a savings bank account. Being a debt fund, they also have favourable taxation. If you sell a debt fund after three years, your gains are termed as long-term capital gains and they are taxed at 20 per cent post-indexation. Indexation adjusts the purchase price as per inflation, thus reducing the tax liability.
- Ultra short-duration funds: Compared to bank fixed deposits with an equivalent or analogous investment tenure, ultra short-term funds typically offer comparable or slightly higher returns. Plus, if you hold the investments for over three years, you have a tax advantage compared to bank RDs, as explained above.
Moreover, like liquid funds, ultra-short-duration funds are highly liquid, ensuring you can easily access your funds in an emergency without paying any penalties.
You can opt for regular investments in these funds via a monthly systematic investment plan (SIP) to build your emergency corpus. However, do remember that returns from debt funds are not guaranteed like bank RDs or FDs.
The Bottom Line
Nobody can predict when an emergency will strike, and for most people, managing finances during that period is the biggest worry. An emergency fund goes a long way in dealing with life’s uncertainties.
