Over the years, many readers have asked us, “can I use X or Y investment for an emergency fund?”. Therefore it may be useful to list all such eligible investments and discuss which is suitable for whom.
Perhaps if you have just started your career and your net worth is low, the following statement may not excite, but with time it could: The instruments you use for your emergency fund depend on your cash flow and net worth. Net worth means all your investments (excluding the emergency fund) minus debt. Self-occupied property should also be excluded.
Let us begin with the essential investment trait suitable for an emergency fund.
It should be liquid. That is, you should be able to redeem it as quickly as possible.
That is it. Taxation, returns etc. do not matter. As your net worth grows, you can create a multi-layered emergency fund, as discussed below. Furthermore, always keep in mind that the size of an emergency fund should constantly be growing (with, say, 5% of your take-home pay). If you dip into it, it will gradually get replenished. All these thumb rules of “fund worth six months expenses” are only rough estimates. To handle reality, the fund ought to be much bigger!
1. Savings bank account: Coupled with a debit card and online access (which today is the norm), it is quite powerful. However, it is not prudent to use the same account for day-to-day expenses (the salary account) and emergencies, as it would be tempting to dip into the emergency fund even for non-emergencies. So we recommend using a separate bank account for this. Of course, we should still not use it unless it is an emergency! Like Dave Ramsey says, “Christmas shopping is not an emergency”. It is poor planning!
2. Flexi-deposits, fixed or recurring deposits: Again, when coupled with online access and instant transfer to an SB account or accessible via debit card. One of these two is enough for young earners.
3. Liquid funds, arbitrage funds, money market funds: As you get more established in your career and take on debt and more responsibilities (spouse, children, ageing parents etc.), you can diversify the emergency fund to these instruments. These are not instantly liquid but can handle emergencies where you can buy some time. Remember that these are in addition to SB acct, flexi-deposit acct etc. and not replacements!
4. Credit card: Once your networth has grown a bit – say, at least five times your credit card spending limit – this can be used to pay off an expense instantly. Naturally, the card dues should be paid before the next due date.
An emergency fund can handle small emergencies when your net worth is low. The fund will ensure your investments are not affected during this time. If misfortune results in huge unexpected spending, borrowing is the only option.
Once your net worth becomes significant, the lines between your emergency fund and your net worth blur. For example, say your emergency fund is about Rs. 5 lakhs (the fund should grow with your networth!). What you do if you suddenly had to spend Rs. 10 lakhs?
At that stage in life, you have options. You can simply redeem Rs. 10 lakh worth of stocks and pay off the sudden expense. Maybe you can make good the “loss” in a few months with your future cashflows.
We should focus our time and energy on accumulating options in life (involving both time and money) instead of worrying about petty things like, “how can I maximise my emergency fund returns?”
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Dr. M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter, Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
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