The Essential Guide to Building and Maintaining Your Emergency Fund
An emergency fund is a critical component of personal finance, often considered a foundational step before engaging in long-term wealth creation. It is essential for financial stability and reduces daily monetary tension.
I. Defining the Emergency Fund and Its Purpose
An emergency fund is money set aside specifically for emergencies. It functions as a financial safety net, allowing you to focus on the problem at hand rather than the finances during a crisis.
The fund serves several key purposes. First and foremost, it handles unexpected crises—those situations for which you were not prepared. The fund provides a cushion during uncertain times, such as the period following widespread job losses seen during the COVID-19 pandemic. These funds are used for situations where other insurance or support might be inadequate or unavailable.
One of the most common uses is covering expenses during job loss, providing survival money until the next job is secured, which could take several months. Medical issues represent another critical use case, covering expenses that insurance may not cover entirely, such as deductibles, treatments not covered, or situations where hospitals do not accept cashless claims, requiring immediate payment. The fund also helps deal with unplanned expenditures like major home maintenance, repairs, or any sudden, mandatory expense.
By having an emergency fund, you avoid making wrong decisions concerning loans or panicking and selling long-term investments like stocks or mutual funds. The emergency fund acts as the base of your investment journey. It ensures that if an emergency arises, you can draw from the fund instead of liquidating investments meant for long-term growth, especially those in volatile instruments like equity.
It’s important to note that the primary purpose of an emergency fund is to be available during an emergency, not to generate high returns. Individuals should not worry about optimizing returns on this specific corpus, as every fund has its own unique objective.
II. Priority and Timing: When to Build Your Fund
You should start building your emergency fund as soon as you begin earning. Before engaging in substantial investment, you should cover three critical areas in personal finance: Term Insurance, Medical Insurance, and the Emergency Fund. If an individual must choose between building the fund or starting long-term investments, the fund should come first.
In the initial years of earning, a higher proportion of your savings should be directed towards the emergency fund to ensure it is created quickly. For instance, if you save ₹10,000 monthly, you might allocate ₹5,000 to the emergency fund and ₹5,000 to investments, or perhaps dedicate all ₹10,000 to the fund initially to reach the target faster. That depends on Individual and circumstances on case to case basis.
III. Calculating the Ideal Amount
The required size of an emergency fund is highly personal and depends on individual circumstances; there is no single fixed amount. A broad range suggested is an amount covering 3 months to 3 years of expenses or income. Falling below 3 months is often considered insufficient.
The appropriate size depends on several variables, including marital status, number of children, and lifestyle. You must consider whether you are supporting dependents such as parents or others, your current expenses including loan EMIs like car loans, rent, or house loan EMIs, and whether both partners in a couple are working—a working couple might need less coverage than a single earner. The health status of dependents is another important factor.
The calculation process involves three main steps. First, identify all mandatory monthly expenses such as groceries, school fees, rent, or EMIs. Second, inflate the total monthly expense by 10 to 15 percent to account for variability and unforeseen costs that might have been overlooked. Third, choose the number of months of expenses you wish to cover, such as 2, 6, 12, or 24 months.
A young person with no dependents or EMIs might manage with 2 to 3 months of coverage, while someone supporting parents, paying EMIs, and having children may require at least a year’s worth of expenses to ensure stability if income stops.
IV. Where to Park Your Emergency Fund (Liquidity and Safety)
The money must be stored in instruments that are safe, secure, and easily accessible. You should aim for a mix of these accessible options. Never invest your emergency fund in active equity mutual funds, index funds, or the stock market. Doing so, risks losing capital, as market crashes like the one in 2020 can wipe out 40 to 50 percent of value when you need it most. Similarly, do not keep the entire corpus in physical cash at home.
Physical cash should constitute 10 to 15 percent of the fund, kept handy for immediate needs when banks may be inaccessible. This provides instant liquidity when you need it most. Savings accounts are good for liquidity and accessibility, with some specialized accounts offering higher interest rates of 6 to 7 percent. These also provide instant access to your funds.
Fixed deposits are safe and can be broken instantly, especially in good banks, making funds immediately available through online banking or mobile apps. Look for FDs with sweep-in facilities where excess savings automatically convert to an FD. Keep in mind that tax is charged annually on accrued interest. For those who understand mutual funds, debt mutual funds offer tax advantages over FDs in some categories and are generally safe.
Liquid funds offer tax deferral. Liquid funds allow instant redemption of small amounts such as ₹50,000. You can invest in 4 different liquid funds and get ₹ 2,00,000 instantly.
Arbitrage funds are suitable if you want to defer tax and potentially benefit from lower long-term capital gains tax rates. They typically provide access to your money within 2 to 3 days.
V. Building and Maintenance
It is crucial to periodically review and top up your emergency fund. The fund amount must be based on your current lifestyle expenses, not your past expenses. Changes in life—such as marriage, having children, or parents becoming dependent—increase your mandatory expenses and require a larger fund size.
Besides saving, focus on increasing your active income. A higher income allows you to save a larger portion each month, provided you do not let lifestyle inflation consume the increased earnings, thus helping you reach your emergency fund target more quickly.
The emergency fund is the foundation upon which future financial independence is built, ensuring that unexpected events do not derail your long-term goals.
Should I Invest My Emergency Fund in Liquid Bees?
What is Liquid BeES?
It’s an ETF (Exchange Traded Fund) that invests in a portfolio of liquid mutual funds. Think of it as a basket of liquid funds that trades on the stock exchange like a stock.
Safety: Yes, it’s relatively safe since it invests in liquid funds (which hold very short-term debt instruments). The underlying assets are low-risk.
Returns: Typically gives 6-8% returns, similar to liquid funds but potentially slightly lower due to the ETF structure.
Liquidity: You can sell it during market hours (9:15 AM - 3:30 PM) and get money in T+1 or T+2 days (1-2 working days).
Not Instant Access: Unlike direct liquid funds where you can get ₹50,000 instantly, Liquid BeES requires you to sell during market hours and wait 1-2 days for settlement.
Trading Required: You need a demat account and must manually sell units on the exchange, which adds a small friction during emergencies.
Market Hours Only: Can’t access it on weekends, holidays, or after 3:30 PM - a limitation during urgent situations.
Slight Price Volatility: Though minimal, there can be small price fluctuations based on demand-supply on the exchange.
Bottom line: Liquid BeES is safe but not the most liquid option. For a beginner, start with simpler options like savings accounts and direct liquid funds first, then add Liquid BeES later if you want liquid mutual funds offer up to ₹50k (or 90% of invested amount, whichever is lower) as instant redemption, 24×7.
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