Life is full of surprises; some are pleasant while the others are not so pleasant and one needs to be prepared for all types of uncertainties that come. Like all the other uncertainties in life, financial crisis can strike anyone, anytime and one needs to be prepared for such financial uncertainties also. Emergency fund, an important armour in your financial planning, not only helps you stay afloat in times like these but also saves you from taking unnecessary debt. Unexpected unemployment, accident, serious illness, disability or many such incidents can affect the regular flow of income. While you cannot control the occurrence of these unexpected situations, you can be prepared for them by having an emergency fund in place to be used in these difficult times.
What is an Emergency Fund?
The corpus of an emergency fund would vary depending upon your financial circumstances after considering your lifestyle, size of the family, number of earning members in the family, loan EMIs and other such recurring expenses that need to be serviced. Ideally it is good to funds to cover at least six months of your living expense.
Liquidity and safety are the two most crucial factors to be considered when it comes to emergency funds.
Conventional Wisdom V/S Financial Wisdom
Conventional wisdom says that emergency funds should be kept in cash, as liquidity is the most important factor when it comes to emergency fund. Many opt to keep such funds in cash either at home or in savings account in their bank as they consider it to be the most liquid and safest option without the erosion of capital. Keeping cash in hand is the most liquid option, but in case of theft one could be left with nothing so keeping huge amount of cash in the house is not a sensible option.
Hence, traditionally people have been keeping such funds in a savings bank account as it is considered both safe and liquid.
But savings accounts offer only 4-6% return per annum and given the high inflation rate the returns generated deteriorate the value of your emergency fund. Emergency funds are not meant to earn you higher returns as the main purpose is to keep the capital safe. However, at the same time the money should be easily accessible. Thus, for the same reason investments in real estate, equity and gold are not considered a part of emergency fund.
Where should you invest your Emergency Fund?
However, the actual returns generated should be positive or at least at par with inflation. Hence one should look at investing in liquid funds, a type of debt mutual funds, which invest primarily in fixed income instruments with lower maturity period.
On an average the return generated by such funds is anywhere between 7 to 8.5% and the redemption is processed within 24 hours. Some fund houses also provide ATM cards to enable investor to directly withdraw from the fund. Thus, one should really consider investing 70 to 80% of his emergency fund into liquid funds as they offer the same benefits as a savings account with a potential of earning higher returns.
Why are liquid funds better than cash?
- The return on investment for Liquid Funds would be higher than the 4-6% that a savings bank account would yield
- The return on investment for Liquid Funds would be higher than inflation so that the real value of the fund rises slightly to substantiate the increase in lifestyle or at least remain constant. This would surely be higher than the real value of a corpus in cash would depreciate over time.
- Chance of theft is not possible for liquid funds whereas that is one of the biggest threats in case of cash.
- Certain liquid funds can be redeemed almost instantly (within a minute in certain funds).
Bottom-line
If you wish to stay ahead of inflation at least, liquid funds are the best place to park emergency corpus. The same can be redeemed over an SMS these days as well.
The smarter way to keep emergency funds would be in liquid funds and it is perfectly safe and easy. So, don’t hesitate. Start with a smaller percentage and you can increase it over time.
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