How to Build Emergency Funds
The Nifty 50 index crossed the 17,000-mark in September 2021 and reached its all-time historical high. Now, you may be tempted to put your surplus funds in the stock market to earn higher returns on your investments.
However, investing in stocks is risky and if the market suddenly crashes, you may lose all your money.
Investing in equities is only recommended if you have a high-risk appetite and surplus money that is not required to meet any emergencies.
What is an emergency fund?
As the name suggests, an emergency fund is a savings buffer that takes care of unexpected liquidity requirements. Emergency corpus is a stash of money that is kept aside for financial surprises in life.
These unexpected events can be costly and stressful and cannot be ignored. Therefore, having a contingency fund will help you tide through financial constraints.
If you do not build such a fund, you may either need to avail of a personal loan or find other expensive alternatives.
To avoid such situations, it is advisable to put aside some money into a safe place that can take care of emergency requirements like unforeseen home repairs, job loss, theft, vehicle breakdown, or an uninsured ailment.
Why do you require an emergency fund?
This fund is an essential corpus maintained to meet emergency financial requirements. It is the money that you can fall back on in unexpected circumstances or a crisis.
Make sure you do not use this money for your regular expenses because it is specifically designed for meeting unexpected financial shortfalls.
When you have adequate funds for an emergency, it helps reduce your stress while dealing with unexpected situations.
Additionally, it ensures you avoid spending money on unnecessary things or a whim while preventing bad financial decisions like taking out an expensive loan.
How much to save within an emergency fund?
There is no general rule applicable to emergency funds, and the corpus depends on your lifestyle and current financial situation.
If you are a bachelor with limited responsibilities, having a fund that covers three to six months of your expenses is adequate.
On the other hand, if you are married with a family and several financial responsibilities, maintaining six to 12 months of your expenses in this fund is recommended.
Things to keep in mind to make an emergency fund
Building an emergency fund can seem daunting at first, but following the steps above will help ensure that this process goes smoothly.
Drawing a quick recap of the above, things to keep in mind while building an emergency fund include the following:
- Set goals for how much you want to save
- Explore different places where those funds should go
- Consider strategies which help grow them quickly while still staying safe
- Research other ways to use the extra cash flow after saving enough
- Decide whether investing those funds is right for you given all the potential risks involved
Where to build an emergency fund?
While creating an emergency corpus, you need to consider safety and liquidity. These funds should be invested in products that are relatively safe and let you withdraw the funds when required without any delay.
Here are four such options to build your emergency corpus.
A savings bank account is the most common and default option chosen by people. You can easily deposit and withdraw the money as and when needed, ensuring complete liquidity.
However, the returns are generally low and range between 2% and 5% on the bank balance. One advantage of a savings account is the tax treatment on the interest earned.
Under section 80TTA of the Income Tax Act, 1961, interest earned on savings accounts is tax-exempt for up to INR 10,000 per annum.
Any interest exceeding INR 10,000 is added to your income and taxed at your prevalent income tax slab rate.
Sweep-in fixed deposits (FDs)
Savings accounts provide a lower rate of interest, and therefore, an alternative option is to invest in FDs. However, FDs have a pre-determined maturity date and premature withdrawals can result in a penalty.
To overcome the hassle of the lock-in period of FDs, you may invest in sweep-in FDs.
The amount in your savings account over the threshold limit is automatically converted to an FD, allowing you to earn a slightly higher rate of interest.
If you need to withdraw more than the balance in your savings account, the FD is automatically broken and the fund shortfall is credited.
Sweep-in deposits offer returns between 5% and 6% while giving you the liquidity of a savings account. One disadvantage of these FDs is that the entire interest income is taxed at your prevalent income tax slab rate.
However, senior citizens enjoy exemption on interest earnings of up to INR 50,000 per year.
Liquid funds and other debt funds
Generally, you do not need to access your emergency corpus frequently, so investing it in other products that provide you with the chance to earn higher returns without compromising on liquidity is recommended.
One such option is liquid fund investments. It is a type of debt mutual fund that has a maturity of fewer than 91 days. Generally, these are high-rated papers and are not affected by the changes in market interest rates.
Presently, the returns vary between 2% and 4% but these can go up to 8% as well. The liquidity is T+1, which means you receive the money the day after making a redemption request.
When you invest in debt funds, taxation is applicable at the time of withdrawal.
Short-term capital gains (STCG) when you redeem the funds before three years are taxed at your prevalent income tax slab rate plus cess.
If you withdraw the money after three years, the long-term capital gains earned are taxed at 20% with the indexation benefits.
You can also invest in other debt schemes like overnight funds. This category of debt mutual funds was introduced in 2018.
The money is invested only for one day, which makes these the safest types of debt funds as there is a low interest-rate risk.
The entire fund corpus is invested in ‘cash or cash equivalent’ instruments like money market securities or overnight reverse repo.
Another type of debt scheme is money market funds that lend to companies for up to one year. The fund managers aim to generate higher returns while controlling the risks by adjusting the lending duration.
These are also one of the mutual fund categories.
Arbitrage funds work on the pricing difference between the spot and futures markets. These funds aim to maximize profit from the difference in the current and future prices of the various securities.
The fund manager buys the security in the cash market while selling it in the derivative or futures market. The profit is the difference between the buying and selling prices in the different markets.
The liquidity of these funds is T+3 days, which means you get your money after three working days from the date of withdrawal.
Depending on the market conditions, the returns can vary between 3% and 5%. If you redeem the fund before one year, any STCG is taxed at 15% plus cess.
However, if you exit the fund after one year, the LTCG of up to INR 1 lakh is tax-free and any profits exceeding this limit are taxed at 10% plus cess without any indexation benefits.
The aforementioned investments are some of the safest and flexible options to build your emergency corpus. If you opt for a savings account or an FD, the returns are low but pre-determined and assured.
Alternatively investing in mutual funds may offer higher returns; however, it is subject to market risks and the returns will depend on the market fluctuations and volatility.
What to do after saving an emergency fund?
After saving enough in an emergency fund, what’s next?
The money is there, mostly lying idle in your bank account, which you may want to incubate, compound, or simply expand, won’t you?
For instance, you may want to consider using the extra cash flow to pay off debt or invest in property rentals if that’s an option available to you.
However, if investing is something you are interested in doing with your funds, there are a few things you should keep in mind before making any decisions, and for starters:
Should I invest my emergency funds? Consider these…
Investing can be a great way to maximise the return on your capital. But experts always ask investors to make sure that they (you) carefully weigh all the risks involved before deciding if this is the right move for them (you) personally.
Two major factors to consider about whether or not you must invest your money saved for emergencies are market volatility and liquidity.
If you are buying highly volatile investments, you may want to consider how that will affect your risk tolerance levels.
Experts insist that you avoid markets with high volatility in case of emergency funds as these markets typically tip in the wrong direction in times of emergencies.
And Murphy's law holds, especially in these cases: anything that can go wrong; will go wrong; and at the worst of times!
The second factor to consider is the ease of conversion, or, in essence, the liquidity of the investment.
Whether it is easy or difficult to convert that investment back into cash is an extremely important factor that one should keep in mind.
Should an unexpected expense arise, your decision will affect your ability to handle the situation.
No one wants to wait days or weeks only to find out they cannot access their funds due to certain restrictions attached to certain investments.
Especially in cases of emergencies and emergencies requiring emergency funds when you need that extra money that you saved up just for such a situation.
By following these expert tips for smart saving and making wise investments based on professional advice, you can tackle any problem no matter what life throws at you:
- Saving for an emergency fund should be your top priority. Experts suggest setting clear goals, both short-term and long-term, and establishing a plan that you can stick with.
- Invest your emergency funds wisely to get the most return on investment (ROI). Do not take too many risks and keep them as accessible as possible.
- Find safe investments with a low-risk profile and low volatility.
- Get professional help. A licensed financial planner can create customised plans tailored specifically to your needs and goals, maximising ROI without unnecessarily exposing yourself.
- Diversify your savings strategies. As experts always say, do not keep all your eggs in one basket.
Frequently asked questions (FAQs)
How much money should you maintain in your emergency fund?
While it is recommended you save between three and six months of your expenses, the amount can vary based on your financial and personal situation.
Consider your necessary monthly expenses, job stability, and lifestyle to determine the balance you must maintain in your emergency corpus.
Where should you invest your emergency funds?
You may choose from different options to invest these funds. You can put approximately 30% in a savings account, 40%-50% in a couple of good debt funds, and balance in the high credit money market or corporate bonds or banking debt funds.
Why shouldn't you keep your emergency fund money in your checking or current account?
It's important to separate your emergency fund from your checking account to avoid any potential overdrafts or other issues. Keeping the money in a separate savings account or another account that isn't easily accessed is ideal so you don't accidentally spend the funds on everyday expenses.
Should I separate savings and emergency funds?
Yes, it's a good idea to keep your emergency funds separate from your regular savings accounts. This way, you can easily access them when needed and won't be tempted to use them for non-emergency expenses. Additionally, by keeping them separate, you'll be able to quickly assess how much money is available should an unexpected expense arise.
What happens if you save too much money over the decided emergency fund?
If you save more than the amount you've decided on for your emergency fund, you may want to consider investing the extra money in stocks or mutual funds. However, it's important to understand the risks associated with investing so you don't put all of your eggs in one basket.
How much should your emergency fund be in your 20s?
This will depend on each individual's lifestyle and income level, but generally speaking, most experts suggest having at least three months' worth of income saved up. This amount can then be increased as needed based on financial goals and other factors, such as marriage or home ownership.
Should I invest my emergency savings in the stock market?
That depends largely on how comfortable you are with taking risks with this type of investment. If you're willing and able to tolerate market volatility, then investing some of your savings into stocks or mutual funds could potentially yield higher returns than a more conservative option like a cash account or a fixed deposit with the bank.
Is it good to keep emergency funds in fixed deposits?
Fixed deposits are a great way to save your emergency funds, as they provide assured returns with zero risk. The interest rates for fixed deposits are often higher than those for regular savings accounts. However, keep in mind that a penalty is imposed if you withdraw the money before maturity. Make sure to read the fine print before investing.
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