What is an Emergency Fund?

How often has life caught us off-guard? Remember all the times when life threw real sour lemons at us and we were unable to lemonade them? It doesn’t take a genius to guess that the only certainty in life lies in its uncertainty. And while so many things that happen to us are beyond our control there is one thing that is totally in our hands. Facing every contingency that life has in store for us with an Emergency Fund!

Why an Emergency Fund you ask?

This fund is second in line to protect you against financial uncertainties. The first is your life/ health insurance. But not everything can be insured. For instance, your monthly rent payment. And you do not want to ask friends and family for a pecuniary favour or break your long-term investments for that matter.

Where to keep Emergency Fund?

Experts suggest that you should maintain an Emergency Fund that covers at least 6-months of your basic expenses. This fund should be highly liquid with no risks attached. Hence, your options here include keeping the funds in cash, savings account, fixed deposit (FD), and liquid mutual funds.

  • Cash – Cash is well, cash. Yes, that cash in your wallet is your Emergency Fund. The catch here is you are not supposed to burn this cash. You need to keep it safe and use it only in an emergency. So set aside some amount of cash from your wallet to some other wallet that is out of your daily reach.
  • Savings account – Here again, create a separate savings account or earmark some amount in your regular savings account or create a recurring deposit (RD), and DO NOT use it until you are in a fix.
  • Fixed Deposit– This is your deposit with a bank against which you get a fixed interest. The FD rates are higher than savings account interest rates. Long-term FDs (5 years or more) provide higher interest. Do note that premature withdrawal of money from FD attracts a penalty.Different banks provide different interest rates. Please check with your banker the interest rate that your bank provides. Also, it makes little sense to keep hopping from one bank to the other to simply earn 1-2% extra interest income.
  • Liquid mutual funds – Allow me to break to you another certainty - your hard-earned money will die a slow (or not so-slow?) death. We often call it inflation. It is here that liquid mutual funds prove to be the most beneficial. They may or may not be able to beat inflation, but they will in all likelihood give you a return at par with inflation. These may, however, take up to 1-2 working days to be liquidated. 

You may also want to keep your tax expense in mind. The tax laws of our country change every year. As of now, redemption of debt mutual funds after 3 years (long-term capital gain) attracts a 20% tax rate with indexation benefit. Interest from savings account is not taxed up to INR 10,000, post which it is taxed at slab rates Interest from FD is taxed at slab rates. Cash, of course, is not taxed at all.

One can choose from any of the options listed above to maintain an Emergency Fund. You may choose to deposit some funds in all of these in varying proportions. Do remember, the idea here is not to make/ grow money, but to have some money handy should we need it one day. 

Should couples decide to go for a joint Emergency Fund? If you guys get along well, you may want to sync your financial life as well. You may decide to have two separate Emergency Funds but make sure you discuss your household expenses and have regular money conversations with each other.

So, make a budget, keep a check on your and your partner’s unnecessary expenses (make sure you don’t become too nosy) and gradually make an Emergency Fund your future self will thank you for. Although we seriously hope that you never find yourself in a situation like that.