How to build an emergency fund

Financial Planning | admin | October 19, 2011 at 9:10 am

Hari and Jyoti Sharma are in their early 30s and have begun to think about their financial roadmap. While they have moved into their new apartment, they have no other investment. Though they are doing well in their jobs, they realise that they should build an emergency fund in case of an unforeseen loss in income. However, they are not sure how to go about it. Should they depend on their credit cards or take a loan against their home to deal with an emergency? They are also wondering if they can fall back on investments in equity mutual funds, since the returns on these are the highest. They need answers to all these questions.

Hari and Jyoti are right about wanting to build an emergency fund. This should be large enough to meet at least three months of their monthly expenses, including loan repayment and insurance premium obligations. For it to qualify as an emergency fund, it should meet some essential requirements. First, it should be easily accessible, and second, the value of the fund should not be subject to fluctuations.

While an investment in equity funds is highly liquid, its value can be down when the funds are needed and beat the purpose of having such a fund. Similarly, home equity loan presupposes an appreciation in the value of the property, which may not always happen. A loan will also increase the liability towards EMI payments, which might be tough to meet when they are facing a loss of income. Although credit cards are commonly used for emergency funding, they come at a very high rate of interest. Hence, Hari and Jyoti should look for an investment such as a bank deposit, where the focus is on liquidity, ensures safety of funds and comes at a reasonable cost.

The investment option that meets these requirements is savings accounts, which is the most liquid, but the yields are extremely low. Most banks offer facilities such as sweep deposits, which combine the higher yield of fixed deposits with the liquidity of a savings bank account. Moreover, bank deposits come with a guarantee up to a specific amount. They can also take a loan against the deposit if their need is temporary.

The couple can also consider liquid funds and short-term debt funds, which offer a reasonable rate of return, are available at a low cost and do not display high volatility in their value. Liquid and short-term funds deploy the money in short-term instruments, and pass on these returns to investors after deducting the costs. These funds can be withdrawn whenever they are needed, and most pay the amount within one working day. There is no guarantee on these funds, but they are managed in a way that the chance of losing value is extremely low.

Hari and Jyoti must work towards building an emergency fund as a priority. All other investments can wait until this is done. As there is a change in their income and lifestyle, their monthly expenses will also go up and require them to augment this fund. They should also review it annually for sufficiency.

Source: Economic Times