Building an emergency fund

It is imperative that every household has an emergency fund that can take care of expenses arising out of any emergency situation, such as hospital bills, loss of job, unexpected household expenses, etc. Since the purpose of the fund is to meet emergency expenses, the accumulated money should be available immediately or at the shortest possible notice. In view of this, emergency fund should not be considered as an investment and so the fund corpus should be parked in such instruments that are highly liquid.

The parking of emergency fund corpus in a liquid instrument is only a standby arrangement which may or may not provide any returns, and if it does, it will provide only minimal returns. Most importantly, emergency fund should never be linked to your financial goals such as children’s education, children’s marriage or your retirement, which should be planned well in advance and for which one should start saving and investing early in life. Remember, emergency fund is for meeting only emergency expenses and not for achieving any financial goals.

Now, the next big question is: what should be the size of the emergency fund? There is no hard and fast rule regarding the size of the fund, but the fund size should factor in the number of dependents in the family and the average monthly income and expenses of the family. So, for a family of four (husband, wife and two children) with an average monthly income of, say, Rs 50,000 and average expenses of Rs 35,000, the ideal emergency fund corpus could be around Rs 2 lakh.

Finally, where does one park the emergency fund corpus? One of the popular option is the savings bank account, where the returns are low (3.5% to 4% p.a.), but the money is accessible any time of the day or night. The other option is to invest in liquid funds, where the returns are comparatively higher (around 8% p.a.) and one can redeem the units and get money on the same day or the next day.