Posted by: Arti Bhargava on Oct 16, 2017, 02.10 PM IST
The D’Souzas are in their early 30s. The young couple is thinking about a financial roadmap. They want to create an emergency corpus before making any investments. The contingency fund is necessary to take care of expenses in case of any unforeseen loss in income.
However, they want to know why can’t they just raise a loan to deal with an emergency. They also cannot understand why the investment they are planning to make in an equity mutual fund can’t be designated as emergency fund.
The D’Souzas understand the importance of an emergency fund. Ideally, the amount should cover three months’ expenses, including loan repayment and insurance premium. First, this money should be easily accessible.
Second, the value of the fund should not be subject to fluctuations.
Third, a loan will increase EMI liability, which might be tough to meet when they are facing loss of income. So taking a loan in an emergency is totally undesirable. While the investment they are considering in equity funds may be highly liquid, its value may be down when the funds are needed and beat the purpose of the fund. They should instead look for an investment where the focus is on liquidity, safety of funds and a reasonable cost.
To this effect, bank deposits are apt as they are easily accessible. However, though savings accounts are highly liquid, the yields are extremely low. Most banks offer facilities such as sweep-in deposits, which combine the higher yield of fixed deposits with the liquidity of a savings account.
Remember, bank deposits come with a guarantee only up to a specific amount (Rs 1 lakh across all deposits). Other options that are suitable for an emergency fund are liquid funds and ultra-short-term debt funds which offer reasonable returns, low cost and a low volatility in value. Liquid and ultra-short term funds deploy the money in short term instruments, and pass on these returns to the investors after cost. These funds can be withdrawn on demand, and most funds pay the amount in one working day.
There is no guarantee on these funds but they are managed in a way that the chance of losing value is very low and the return is kept stable and consistent. The D’Souzas must make an emergency fund a priority. All other investments can wait. As their income and lifestyle changes, their monthly expenses will go up and require them to augment this fund. The fund needs to be reviewed at intervals.
BANKING AND CAPITAL MARKETS
Get the training you need to work in the Banking and Capital Markets industry through this intensive course