How to build an emergency fund

The financial problems caused by the pandemic has made everyone realise the importance of maintaining an emergency fund. Normally, one should stash away enough money to take care of 2-3 months’ household expenses.

But as things are panning out, it seems one needs anemergency fund to sustain the household for at least six months. In other words, if one’s monthly expenses are Rs. 40,000- Rs. 50,000, one should have a contingency corpus of at least Rs 2.4 lakh to Rs 3 lakh.

It is not easy to build a big corpus immediately, especially when individuals have very little surplus due to salary cuts and assets can’t be sold because stock markets are down. However, regular and disciplined savings can help you achieve this goal. Here are a few tips on how to save and where to invest.

Automate your savings: Most people are not able to save because there is not much left after their monthly expenses. However, if one puts away some money just when the salary hits the bank account, the savings target won’t be missed. Monthly savings of Rs 10,000 which earn 7% returns will build a corpus of Rs 2.6 lakh in two years. Don’t let the COVID-induced lockdown stop you from starting off. Almost all banks offer net-banking facilities and transactions can be done online without visiting the branch.

Bolster kitty with windfalls, maturing investments: Two years is a very long time and emergencies may crop up before you have enough in the kitty. Apart from monthly savings, you
could direct windfall gains such as tax refunds or maturing investments towards the emergency fund. Given the slowdown in the economy and the lockdown, it is unlikely that the corporate sector will report very rosy numbers for 2019-20. So even though there won’t be a fat bonus this year, whatever comes your way can be directed to the contingency corpus.

Focus on liquidity: The emergency fund should be accessible to you at short notice, so make sure you choose the right saving option. Keeping cash in the almirah locker is not a sensible option, but neither is the savings bank account that earns a paltry 3-4%. Some banks offer sweep-in savings accounts where cash beyond a predefined limit flows into fixed deposits to earn higher returns. This is a good option but check if your bank offers such a facility.

Breaking deposits is difficult: Another option is a recurring deposit where you contribute every month and get the cumulative amount on maturity. Though recurring deposits can be
broken anytime by the investor, the problem is that they cannot be broken in parts. If you need a small amount to tide over an emergency, you will have to foreclose the recurring deposit and take the entire money out. To counter this problem, you can have multiple recurring deposits or open fixed deposits every month which will add to your paperwork.

Tax implications: Keep in mind that the interest on bank deposits is fully taxable at the marginal rate applicable to you. In the highest 30% tax slab, this can be very taxing.
Instead of tax unfriendly bank deposits, one can consider mutual funds which have a distinct tax advantage over bank deposits. Gains from mutual funds are treated as capital gains and get taxed at a lower rate of 20% if the holding period exceeds three years. The investor is also eligible for indexation benefit which adjusts the purchase price upwards by taking into account the inflation during the holding period.

Choose the right mutual fund: Mutual funds are better repositories of emergency cash because they let you withdraw and invest whenever you want and whatever amount you need.
However, be very careful when choosing a mutual fund. In recent times, investors have suffered heavy losses because debt fund managers took risky bets to earn better returns. Six debt funds of Franklin Templeton Mutual Fund with almost Rs 30,000 crore of investor money have been closed down by the asset management company. The money cannot be withdrawn now and will be paid only when the bonds mature or are sold off. Investing the emergency corpus in a scheme like that is as good as not having one. Liquid schemes and overnight funds may be a better option. Go for schemes that hold very highly rated paper.

(The writer is Managing Director, MyMoneyMantra.com)