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We save and invest to secure our future. But we may be overlooking the one thing that can undo all these efforts: an emergency. Think of the times when you had to use your already overdrawn credit card to meet a medical emergency or when you had to sell, maybe even at a loss, the investments you had been building for long to pay that equated monthly instalment (EMI) and the effect it had on your finances and goals. The way to protect your financial security is to ensure that you are in a position to meet your essential expenses and emergencies without disturbing investments and savings earmarked for future needs, even if your regular income stops or reduces for any reason. You do it by building an emergency fund.

Why an emergency fund

Your income is earmarked to meet your regular financial obligations. This includes the living expenses, repayment of loans and planned savings and investments. Your savings and investments are spoken for to meet your goals. You would have invested in long-term investments and there may be a penalty or loss of value if they are withdrawn earlier. Then how would you deal with a financial emergency? A loss of job, a cut in income, an unforeseen expense—are all situations that call for access to funds that can help you tide over the shortage of income.

You cannot forecast emergencies and unplanned expenses, but you can estimate what you need to take care of your regular expenses, including loan repayments. Ideally, you should prepare to set aside funds to cover at least 3 to 6 months of expenses. This would be your backup to meet any unexpected need for funds. In the absence of an emergency fund, you would be forced to borrow, or liquidate existing investments—maybe even at a loss. Your credit score will take a hit with the additional debt. Paying off the debt will be a drain on your income and delay all your other investment plans for a long time.

Hold it liquid and safe

The primary requirement from your emergency fund is that there are no restrictions on accessing the money when you need it. The investments in which the funds are held should provide a high degree of liquidity and there should be no lock-in, costs or penalties associated with withdrawing the funds early. The process of withdrawing funds should be simple. And this investment should not see its values fluctuating or have the risk of being forfeited. Consider a situation when you need the funds but find that the values are down or the funds are gone. The whole purpose of a safety net is lost. The investment for emergency funds should ideally be liquid, with a high degree of safety and stability in returns. This is not an investment where the investor should look at maximising returns.

A savings bank account ticks all the right boxes. It provides high degree of safety and you can withdraw the funds without restrictions. A money market mutual fund scheme is also a good choice. While the returns are not a priority while selecting the products to hold emergency money, the fund can be structured to earn better returns without compromising on the essential liquidity and safety features.

One good option would be to ladder the investments. Laddering is done by splitting the total funds into segments, as it is unlikely that you will need the entire amount at the same time. The first tranche is invested for liquidity, in a product like the savings account, so it can be withdrawn at any time. The portion of total funds that you will hold in the first tranche will depend on your financial situation. If you have a steady income, which is adequate to meet your expenses and are well equipped to manage emergencies such as adequate health insurance cover, then you need only a small portion of your total emergency fund in this category. But if your income is unstable and often not enough to meet your essential expenses, then you may need more of your funds in the first tranche as you are likely to fall back on it more often. The second tranche can have slightly longer holding periods such as short-term bank deposits and ultra-short term mutual funds. They earn better returns and can also be withdrawn at short notice. The last category can be investments with longer holding periods for better returns, as you are likely to have more time to liquidate these, and you may not have to sell at a loss if the values were down or to avoid a penalty on early withdrawal.

Estimate the amount you need in your emergency fund and use your savings first to build it. You may already have some investments that meet the liquidity and safety criteria that can be earmarked for the emergency fund. Once you have assigned it for this purpose you cannot use it for any other goals or needs.

Use with discretion

The emergency fund is not for you to spend as you please. It is for use in an emergency or to meet essential expenses. If you use the fund at any time make sure you replenish it as soon as possible. As your income and expenses go up, your emergency fund requirement will also change and you will have to top the fund periodically. The emergency fund is your primary protection against vagaries of your income. Use it with discipline so that it serves the purpose of giving you financial security.