In our previous post, we explained what an emergency fund is, its features and why we should create an emergency fund. If you have missed it, here’s a quick recap.
An emergency fund is a corpus that will help you meet all your unforeseen expenses without compromising on your needs. Having an emergency fund is a must, as it helps you lead a financially stress-free life.
The key to a good emergency fund is liquidity. In other words, you should be able to access the fund anytime. And, the focus of an emergency fund should be on building a significant corpus, and not chasing returns. Hence, emergency fund investments should not be volatile.
Moving ahead, let’s understand how to build an emergency fund and where to invest to create the desired corpus.
How To Build an Emergency Fund?
We cannot build an emergency fund overnight. It requires a consistent effort to reach the target of your fund requirements. Ideally, you should set aside a certain amount every month to build your emergency corpus. However, you shouldn’t use these funds for any expenses, but save them for only emergencies.
A popular misconception in society is ‘I don’t need an emergency fund; I already have Rs 1,00,000 in my bank account for a rainy day.’ Fair enough, but how many of you have assessed if the amount is enough to meet your financial obligations, and for how long can you depend on this corpus?
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These two questions lay the foundation for determining how much emergency fund is enough. Experts suggest having a corpus worth six to eight months of your salary. However, the emergency fund requirements vary from individual to individual. Therefore, you need to assess your financial position and other requirements carefully. Following are certain things that you should keep in mind:
Ideally, you should bifurcate your emergency fund as a short-term and long-term fund.
Short-Term Emergency Fund: Your primary motive should be liquidity with a short-term emergency fund. High liquidity should be the target rather than high returns. A short-term fund should be able to address your emergency cost on short notice. Savings bank accounts, liquid mutual funds, and short-term fixed deposits are suitable options for creating a short-term emergency fund.
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Long-Term Emergency Fund: On the other hand, a long-term emergency fund should help you cover large-scale financial requirements. For example, a medical emergency or a major natural disaster. For such a fund, immediate liquidity is not mandatory. You can invest in schemes that can be easily liquidated in a couple of days, such as liquid funds and fixed deposits. These schemes offer you slightly higher returns and, at the same time, require a couple of days to liquidate.
Where to Invest to build an Emergency Fund?
Finally, the most important question is where & how to keep my emergency fund invested. Researching and planning your emergency fund is worthless if you don’t take action. You need to invest to see the corpus come to life. Investing in the right strategy will help you create the corpus faster.
Among a wide range of investment options, it often becomes confusing to narrow down on a scheme. Following are some investment options that you can consider to create your emergency fund:
Liquid Mutual Funds: Liquid funds are a good investment option for creating your emergency fund. These schemes invest across money market instruments that mature in 91 days. The risk levels are low, returns are more or less predictable, and offer high liquidity. Historically seen, some liquid funds have given an 8% return. Therefore, these funds are ideal for an emergency fund.
Fixed Deposit: A deposit scheme with a lock-in period ranging from 1 year to 10 years. However, it offers guaranteed income. A low-risk scheme that helps you create a long-term emergency corpus.
Taxation
Tax is a major expense that we all often tend to ignore. Taxes reduce the net return from your investments. Therefore, it is essential to consider the tax implications while choosing an investment to create your emergency fund.
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Liquid mutual funds are a type of debt mutual funds that attract short-term capital gains and long-term capital gains based on the investment duration.
Investments held in debt mutual funds for less than three years attract short-term capital gains tax. The gains are added to your taxable income and taxed per your income tax slab rates. On the other hand, for investments held for more than three years, the long-term capital gains are taxed at 20% with indexation benefits.
Fixed deposits have a lock-in period, and the interest earned is taxable as per your income tax slab rate. Be it for the long term or short term; the taxation criteria remain the same for fixed deposits.
Therefore, when the investment duration is over three years (long term), and you fall under the highest tax bracket, debt mutual funds are more tax-efficient than fixed deposits.
Conclusion
Without planning and investing, you cannot achieve financial freedom. Always review your emergency fund from time to time. Assess your financial requirements and update your emergency fund based on the new requirements. Staying up to date with your investments will help you lead a financially stress-free life.
If you haven’t already created an emergency fund for yourself, do it now. As the saying goes, “Better Late Than Never”, start creating your emergency fund today.
No one size fits all solutions for creating an emergency fund. It’s a personalized strategy that one should carefully consider. Are you having thoughts of building an emergency fund? Are you confused about the process of identifying a suitable corpus for your emergency fund? Are you looking for personalized financial assistance? Let us help you build an emergency fund, and you can thank us later.
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