Emergency Fund Essentials: Building Financial Security with Fixed Deposits

Life is filled with unexpected twists, and predicting what lies ahead is consistently challenging. This is why preparedness is absolutely crucial. Any form of uncertainty, particularly in terms of the main breadwinner’s lifespan or the welfare of dependents, has the potential to create disruptions both in our daily lives and financial stability for all those concerned. To guard against such uncertainties, having an emergency fund is essential.

In this article, we will delve into the concept of an emergency fund and examine various approaches to establishing one, ensuring that you are adequately equipped for unforeseen twists in life.

What is an Emergency Fund?

An emergency fund functions as a monetary safety cushion. It constitutes reserved funds designated to assist individuals in managing unforeseen financial difficulties. Such challenges may encompass scenarios like job loss, salary reductions, unanticipated medical emergencies lacking insurance coverage, or the need for sudden travel.

Imagine an individual experiencing an unforeseen circumstance, such as losing their employment. Even if funds are available in their bank account, they might prove insufficient, particularly if the process of securing a new job is prolonged. In such a situation, the individual requires immediate financial assistance to address daily expenses and fulfil crucial financial obligations, such as monthly EMIs.

How Much Emergency Fund is Sufficient?

Determining the suitable size for your emergency fund is contingent upon variables like your age and monthly expenditures. A standard advice is to aim for an amount large enough for six to nine months of expenses. 

For example, if you bring in ₹60,000 each month and ₹40,000 of that goes to your basic nee­ds, your emergency fund should be between ₹2,40,000 to ₹3,60,000 (calculate­d by multiplying ₹40,000 by either six or nine).

When determining your monthly expenditures, remember to include everyday bills. But don’t forget to factor in things like EMIs and insurance instalments. While this might appear to be a significant amount, particularly if you’re starting with no savings, creating an emergency fund is an achievable objective. 

The essential strategy is to cultivate the habit of allocating a portion of your income each month, progressively building up your emergency fund over time.

How to Build an Emergency Fund?

Building a reliable emergency fund involves the judicious selection of low-risk investment options. Here are various strategies you can employ to ensure you have a financial safety net.

• Savings Account

Kickstart your emergency fund journey by opening a dedicated savings account. This serves as the bedrock of your financial safety net. It’s crucial to commit to a disciplined approach, resisting the temptation to dip into these funds for non-emergencies. Consider creating a separate bank account solely for emergencies to reinforce your commitment to safeguarding these vital funds for unforeseen challenges.

• Recurring Deposits 

Embracing a recurring deposit plan can offer slightly superior returns, typically ranging between 4% to 8% per annum. However, it’s crucial to be aware that premature withdrawal from RD investments may attract penalties. Additionally, the interest earned is subject to full taxation based on your income tax slab.

• Fixed Deposits

Designating an existing FD as your emergency fund or investing a lump sum in a new FD can provide higher returns based on the FD tenure. It’s essential to note that FD returns are taxable in accordance with your tax slab, and breaking an FD prematurely may lead to penalties.

Also Read More About Fixed Deposit (FD)

• Liquid Funds

Liquid funds stand out as a compelling choice for building an emergency fund. These low-risk debt funds channel investments into short-term bonds, offering returns higher than those from a standard savings account. Gains from selling a debt fund after three years are categorised as long-term capital gains, taxed at a rate of 20% post-indexation. Indexation adjusts the purchase price for inflation, thereby mitigating the tax liability.

• Ultra Short-Duration Funds

Explore ultra-short-duration funds as part of your investment strategy. They can offer returns comparable to or slightly higher than traditional bank fixed deposits. Holding onto these investments for over three years provides tax advantages compared to bank RDs.

Similar to liquid funds, ultra-short-duration funds ensure high liquidity, allowing easy access to your funds in emergencies without penalties. This liquidity ensures that your emergency fund remains responsive to unforeseen financial needs.

Conclusion 

The unpredictable nature of life leaves us vulnerable to unforeseen emergencies, and for many, the greatest concern lies in managing finances during these challenging times. An emergency fund stands as a stalwart companion, offering a financial buffer that goes a long way in navigating life’s uncertainties. By diligently building and maintaining this fund, you not only gain peace of mind but also equip yourself with a resilient financial safety net, ensuring that you are better prepared to face whatever unexpected twists life may present.

FAQs

Why do I need an emergency fund?

An emergency fund is crucial for unexpected financial challenges like job loss or medical emergencies. It provides a financial safety net, ensuring stability during uncertain times.

How much should be in my emergency fund?

The ideal amount varies, but a rule of thumb is 6-9 months of expenses. This ensures a financial cushion to navigate unforeseen challenges without specifying any particular monetary value.

Where should I keep my emergency fund?

Consider options like savings accounts, recurring deposits, or liquid funds. Each has pros and cons, so choose based on your risk tolerance and liquidity needs.

Can I use investments for an emergency fund?

Yes, opt for low-risk investments like liquid funds or ultra-short-duration funds. They offer potential returns while ensuring easy access to funds during emergencies.