The Nifty 50 index crossed the 17,000-mark in September 2021 and reached its all-time historical high. Now, you may be tempted to put your surplus funds in the stock market to earn higher returns on your investments.
However, investing in stocks is risky and if the market suddenly crashes, you may lose all your money.
Investing in equities is only recommended if you have a high-risk appetite and surplus money that is not required to meet any emergencies.
What is an emergency fund?
As the name suggests, an emergency fund is a savings buffer that takes care of unexpected liquidity requirements. Emergency corpus is a stash of money that is kept aside for financial surprises in life.
These unexpected events can be costly and stressful and cannot be ignored. Therefore, having a contingency fund will help you tide through financial constraints.
If you do not build such a fund, you may either need to avail of a personal loan or find other expensive alternatives.
To avoid such situations, it is advisable to put aside some money into a safe place that can take care of emergency requirements like unforeseen home repairs, job loss, theft, vehicle breakdown, or an uninsured ailment.
Why do you require an emergency fund?
This fund is an essential corpus maintained to meet emergency financial requirements. It is the money that you can fall back on in unexpected circumstances or a crisis.
Make sure you do not use this money for your regular expenses because it is specifically designed for meeting unexpected financial shortfalls.
When you have adequate funds for an emergency, it helps reduce your stress while dealing with unexpected situations.
Additionally, it ensures you avoid spending money on unnecessary things or a whim while preventing bad financial decisions like taking out an expensive loan.
How much to save within an emergency fund?
There is no general rule applicable to emergency funds, and the corpus depends on your lifestyle and current financial situation.
If you are a bachelor with limited responsibilities, having a fund that covers three to six months of your expenses is adequate.
On the other hand, if you are married with a family and several financial responsibilities, maintaining six to 12 months of your expenses in this fund is recommended.
Where to build an emergency fund?
While creating an emergency corpus, you need to consider safety and liquidity. These funds should be invested in products that are relatively safe and let you withdraw the funds when required without any delay.
Here are four such options to build your emergency corpus.
Savings account
A savings bank account is the most common and default option chosen by people. You can easily deposit and withdraw the money as and when needed, ensuring complete liquidity.
However, the returns are generally low and range between 2% and 5% on the bank balance. One advantage of a savings account is the tax treatment on the interest earned.
Under section 80TTA of the Income Tax Act, 1961, interest earned on savings accounts is tax-exempt for up to INR 10,000 per annum.
Any interest exceeding INR 10,000 is added to your income and taxed at your prevalent income tax slab rate.
Sweep-in fixed deposits (FDs)
Savings accounts provide a lower rate of interest, and therefore, an alternative option is to invest in FDs. However, FDs have a pre-determined maturity date and premature withdrawals can result in a penalty.
To overcome the hassle of the lock-in period of FDs, you may invest in sweep-in FDs.
The amount in your savings account over the threshold limit is automatically converted to an FD, allowing you to earn a slightly higher rate of interest.
If you need to withdraw more than the balance in your savings account, the FD is automatically broken and the fund shortfall is credited.
Sweep-in deposits offer returns between 5% and 6% while giving you the liquidity of a savings account. One disadvantage of these FDs is that the entire interest income is taxed at your prevalent income tax slab rate.
However, senior citizens enjoy exemption on interest earnings of up to INR 50,000 per year.
Liquid funds and other debt funds
Generally, you do not need to access your emergency corpus frequently, so investing it in other products that provide you with the chance to earn higher returns without compromising on liquidity is recommended.
One such option is liquid fund investments. It is a type of debt mutual fund that has a maturity of fewer than 91 days. Generally, these are high-rated papers and are not affected by the changes in market interest rates.
Presently, the returns vary between 2% and 4% but these can go up to 8% as well. The liquidity is T+1, which means you receive the money the day after making a redemption request.
When you invest in debt funds, taxation is applicable at the time of withdrawal.
Short-term capital gains (STCG) when you redeem the funds before three years are taxed at your prevalent income tax slab rate plus cess.
If you withdraw the money after three years, the long-term capital gains earned are taxed at 20% with the indexation benefits.
You can also invest in other debt schemes like overnight funds. This category of debt mutual funds was introduced in 2018.
The money is invested only for one day, which makes these the safest types of debt funds as there is a low interest-rate risk.
The entire fund corpus is invested in ‘cash or cash equivalent’ instruments like money market securities or overnight reverse repo.
Another type of debt scheme is money market funds that lend to companies for up to one year. The fund managers aim to generate higher returns while controlling the risks by adjusting the lending duration.
Arbitrage funds
These are also one of the mutual fund categories.
Arbitrage funds work on the pricing difference between the spot and futures markets. These funds aim to maximize profit from the difference in the current and future prices of the various securities.
The fund manager buys the security in the cash market while selling it in the derivative or futures market. The profit is the difference between the buying and selling prices in the different markets.
The liquidity of these funds is T+3 days, which means you get your money after three working days from the date of withdrawal.
Depending on the market conditions, the returns can vary between 3% and 5%. If you redeem the fund before one year, any STCG is taxed at 15% plus cess.
However, if you exit the fund after one year, the LTCG of up to INR 1 lakh is tax-free and any profits exceeding this limit are taxed at 10% plus cess without any indexation benefits.
The aforementioned investments are some of the safest and flexible options to build your emergency corpus. If you opt for a savings account or an FD, the returns are low but pre-determined and assured.
Alternatively investing in mutual funds may offer higher returns; however, it is subject to market risks and the returns will depend on the market fluctuations and volatility.
Frequently asked questions (FAQs)
How much money should you maintain in your emergency fund?
While it is recommended you save between three and six months of your expenses, the amount can vary based on your financial and personal situation.
Consider your necessary monthly expenses, job stability, and lifestyle to determine the balance you must maintain in your emergency corpus.
Where should you invest your emergency funds?
You may choose from different options to invest these funds. You can put approximately 30% in a savings account, 40%-50% in a couple of good debt funds, and balance in the high credit money market or corporate bonds or banking debt funds.
This is a companion discussion topic for the original entry at https://jupiter.money/resources/how-to-build-an-emergency-fund/