Why it's important to have emergency fund!

Most of us are happy while investing, and more so when we earn decent returns over a few years. But what should you do in case you need funds urgently? Remember, emergencies always arrive unannounced, so you must plan well in advance to combat it. An emergency fund takes care of all these problems. Let’s understand why it’s important to have an emergency fund, and where should you be investing them.

When troubles knock at your door, your emergency fund can serve as financial shield. Many times, you might be in urgent need of funds, like during an accident, illness, wage reduction, job loss or the death of a family member.

Why is an emergency fund necessary?
An emergency fund serves as a financial cushion during tough times. It helps you avoid taking a loan and continue your investments and SIPs, so that you continue to reap benefits of long-term investing. Often, people break into their investments to tide over tough times.

How big should your emergency fund be?

You can never estimate the quantum of the troubles that hit you. They could be as small as your car breaking down, or as significant as losing your job, which could last for months. In such a case, not only will you have to take care of  your regular household expenses, but also meet other financial liabilities like paying EMIs or credit card bills. That is why it is advised that one should create an emergency fund that can take care of your family’s expenses for at least 3-6 months.

To create an emergency fund, first calculate all your monthly expenditure. Then estimate the amount you are left with. Out of this, allocate a fixed amount to your emergency fund. Also, earmark any surplus or additional money you have towards this emergency fund.

The foremost aim of an emergency fund is to help you financially, without delay, and step in when you are in dire need of funds. In some situations, you might need money within a few hours or days. That is why, one part of your emergency fund should be always highly liquid, or one that is available immediately. This potion can be kept as cash or in a savings account. About 1 month worth of expenses can be set aside like this.

The remaining of your emergency fund corpus can be invested in a Fixed Deposit. This will earn you higher returns than a savings account. FDs are also highly liquid, meaning that you can get your funds within 1 working day. However, you will have to pay a penalty in case of premature withdrawals.

You can opt for sweep-in FDs, as well. Under this, any excess amount in your savings account is automatically transferred to your FD account. Similarly, if funds in your savings account fall below a certain threshold, funds from FD account are added to it.

For emergency funds, you can also take help of recurring deposits or RDs. You can start by investing a small amount every month. However, the interest you earn will stay fixed.

If you do not have an emergency fund, start planning for it right away, so that your investments can continue even during a financial crisis. Many experts suggest putting away some part of mutual funds in a liquid mutual fund. This offers higher returns as compared to savings accounts and in some cases, FDs. While they generally offer up to 8-9% returns, this depends on the market conditions. As compared to FDs, they offer lower liquidity. It takes 1-3 days for funds to be credited back after redemption, but there is no penalty on premature withdrawal.