The next thing to put your money in - Emergency Fund

As I had written in the previous post, the first place that you should put money, is an insurance policy. If you haven’t read that post, you can read it here.

This post will speak about the next thing you should put your money in, after you’ve bought insurance. And that’s an Emergency Fund.

The last year, 2020, has shown us that adversity can strike any moment, and for reasons beyond our control. And Covid-19 was just one kind of adversity. People lost their jobs, companies shut down, affected patients had to spend a bomb on healthcare costs etc etc. Adversity can strike in any form. You may have some unforeseen expense come up, you may lose your job, a health issue may force you to not work for a few months (I’ve known someone who fractured his back and was on bed-rest for 5 months, without pay. In his case, his insurance covered for his medical bills, but could not cover his monthly expenses, and his whole family had a hard time for those 5 months). There are hundreds of such scenarios possible, where you may have some sudden expense or lose your stream of income.

That’s why you need an emergency fund.

So what is an emergency fund exactly? It’s nothing but a kitty of money which you save for any such emergency.

As a rule of thumb, 6 months worth of expenses should be saved in an emergency fund so that if, God forbid, there is an emergency, you won’t need to go and borrow money from people. So if your monthly expenses are say, Rs. 20,000, you should have about 1-1.2 lakhs in an emergency fund.

Now, this emergency fund needs to be liquid. By “liquid”, I mean that this money should be saved in a place where you can easily withdraw it for usage. So that means you cannot invest it in any scheme that has a lock-in period. It needs to be in a scheme or instrument where you can withdraw the money in less than a day. Also, you can’t put it in the stock market or an equity mutual fund, because while they are easy to liquidate, they are ideally long-term investments, and therefore may not give you good returns if you want to withdraw the money in less than 2 years. So you can either keep it in your bank account, or, if you want to earn some better interest on it, you can put it in another form of investment.

Enter liquid funds.

A liquid fund is a mutual fund which is very low risk and can be liquidated immediately. That is, the money can be withdrawn almost immediately. Disclaimer: while it is extremely low risk, it isn’t zero risk. But the risk-return ratio may be worth it.

However, if you are extremely risk averse, you’d be better off putting this money in a Fixed Deposit with the bank. Please note, however, that most banks charge a penalty if you want to liquidate your FD before the maturity period. Also, the interest rates these days are pretty low. So if you want some interest, you’d rather keep your emergency money in a liquid fund. Some liquid funds also charge some money if you liquidate within a week or a month, but that amount is pretty low. It’s called Exit Load. We’ll talk about Exit Load when we cover Mutual Funds, but for now, just understand that some Mutual Funds charge some penalty if you withdraw the money before a certain duration (determined by the fund). That is called the Exit Load.

All in all, if you are extremely risk averse and don’t care about returns, keep 6-month worth of expenses in a separate savings account which you will not touch for normal expenses. If you want to earn some interest, put it in a Fixed Deposit. And if you want to earn better interest with a slight risk, put it in a Liquid Fund. Do calculate the exit loads for the liquid fund and the penalty for breaking the FD though, and then decide where you want to put the money.

If you’ve read my earlier post, you’ll understand that this money should not be from a purpose of “investment”. It should be from a purpose of“saving”. You don’t need to aim for good returns. All you need to aim is for this money to be available when you want it (If you don’t know the difference between saving and investing, read it here).

If you’ve reached till the end of this post, congratulations! Now that we’re done discussing insurance and emergency funds, we’ll soon be talking about “investing” money in Mutual Funds.

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