Where should your emergency fund sit, and how large should it be?

An emergency fund, as the name suggests, is the money that can come to your rescue in case of an unexpected large financial requirement. Let’s break down how you can build your emergency fund as a safety net for a safe and secure life.

When does an emergency fund matter most?

The existence of an emergency fund matters most if you encounter a financial setback, such as a job loss, health emergency, home repair or some family responsibility that cannot be said no to or postponed. With an emergency fund in place, you still get to enjoy financial independence, without having to depend on friends or family or external sources for loans, sometimes borrowed at heavy interest rates.

How much should you save for an emergency fund?

Financial experts always recommend saving at least up to 6 months of your monthly spending as an emergency fund. However, this depends on other factors. Here’s a lowdown:

 

• If you have a stable job and no dependents:

If you have a stable job and no dependents, you need to save at least three months’ expenses.

 

• If you are married, have children: 

Here, you ideally need to save at least six to nine months of your expenses, especially since you have dependents.

 

• If you are self-employed or have an unstable job: 

Here, you need to save at least 12 months of expenses to ensure you are not financially burdened. Also, in case you have a family and dependents, you must revisit the amount saved to ensure steadiness.

Where to invest your emergency fund?

You should invest in instruments such as a savings account, fixed deposits and liquid mutual funds for an emergency fund. Note that while investing in an emergency fund, the idea is to have readily available money in a time of crisis. Expecting returns from this money is the secondary objective.

Savings account

Savings accounts are a safe instrument that can be accessed readily. The interest received on this is mostly 2.5-3.5 per cent. This should be where at least the first three months of the emergency fund can be parked.

Fixed deposits

These can be accessed within one day and are also considered a safe investment instrument. However, you need to be aware that there are penalties and reduction in interest rates on premature withdrawals. The returns on this are a little more than the savings account — 5-6 per cent. Short-term fixed deposits with auto-renewal facility are a common and safe way to build your emergency corpus.

Liquid mutual funds

These can be redeemed the next day. If redeemed on a Friday, you get access to your funds on the forthcoming Monday. However, you can get an instant redemption of up to ₹50,000 immediately, which can prove useful in a time of crisis.

 

Mistakes to avoid when investing for emergency fund

There are some mistakes that most people often make while investing for emergency funds. Here are some:

• Do not invest in an account that is not easily accessible. That will defeat the purpose.
• Do not use a credit card as a standby because that would be akin to taking debt.

Steps to follow to build your emergency fund

Here is a step-by-step process to follow to build your emergency fund.

 

• Calculate your monthly expenses towards necessities such as food, water bill, electricity, fuel, home loan equated monthly instalment (EMI), rentals, school fees, medical expenses, insurance premiums, etc.
• Once you get the figure, check which category you belong to and accordingly set a target. For instance, if you think you are in an unstable job and your monthly expenses are around ₹1 lakh, you can prepare to save ₹12 lakh for the rainy day.
• Next, set the timeline by which you can achieve this target. If you decide to set aside ₹25,000 towards an emergency fund, you may take close to 2 years for the same. You can extend the timeline or the money to be invested according to your income.

When should you use your emergency fund?

An emergency fund should be used only in the time of an emergency — only emergency needs, not wants. Do not use money from this fund for vacations or investing in riskier instruments offering higher returns. Whenever you use any part of the emergency fund, ensure that you replenish it as soon as possible.

FAQs

How many months of expenses should the buffer cover?

The expenses that a buffer should cover depends on whether you are single or have dependents, have a stable or unstable job, etc.

Should the money sit in a savings account, fixed deposit, or liquid fund?

Your primary emergency — three months worth of expenses — can be parked in a savings account. Some investment should go to fixed deposits. And a large part of the emergency fund should ideally be invested in liquid mutual funds.

When is it right to use the buffer and how fast should it be rebuilt?

An emergency fund should be used only in times of crisis. Once you have recovered from the financial situation, you must again build your emergency fund.