A 10 Min Diary: The Emergency Fund
Planning a safety cushion for a soft landing
We live in a very uncertain world. As a technologist, I have seen big shifts in the industry over the last few years.
We have seen AI enter into almost every aspect of work. We have seen several mass layoffs. We have seen countless burnout stories too.
Life can be unpredictable, and change is the only constant.
In this diary, I want to share all my thoughts on creating an “emergency fund” that acts as a safety cushion and helps you with a soft landing when faced with unforeseen situations.
When things go wrong, we have no option but to face it, but with good planning, we can at least ease the pain and uncertainty a little.
Hopefully, such a situation never happens, but it is never too late to be prepared, just in case.
Disclaimer: As with all perspectives and ideas, always do your due diligence and analysis to understand what works for your unique context.
Why plan an emergency fund?
- The inner peace of mind, knowing that you can fund sudden expenses or continue life as usual even if you stop working or get laid off.
- Building leverage to comfortably take career breaks when required or quit jobs that don’t align with you before you have a new offer.
- Not worrying about where to get money from when you need it.
- Avoiding the risk of prematurely withdrawing your investments from mutual funds or equity, which were set aside for long-term goals.
- Avoiding the risk of requiring to take personal loans at high interest rates or take loans against any of your assets like real estate or MFs.
Having this planned out can build confidence and the leverage required to make key decisions in life, even when there is no emergency.
What should an emergency fund be made of?
You need to have quick access to this amount. So, it should be something that is easy to liquidate~ like money in an FD that can be withdrawn anytime.
The opportunity cost of premature withdrawal should not be high. So, no stocks or equity-based products must be used.
Real estate doesn’t fit into this either.
Planning the structure of an emergency fund
Here’s a short, straightforward answer if you don’t want to optimize things. Keep a fixed deposit that can cover up to 1-2 years of your living expenses.
If you want to plan this out more intricately, read below.
Else, skip to the bottom.
I diversify this fund into three levels.
Level 1
The money you put in your savings account that is beyond the regular monthly expenses.
As an example, let’s assume that your average monthly living expenses are 50K INR. At any given month, you will have a lot more amount than 50K in your savings account.
You may not want to have too much in your savings account as the interest you get is very low.
One can keep 3–6 months of expenses directly in the current account. In our example, that would be up to 3 L.
If you ever need something immediate, right now, you can directly pay it up with your debit card or/and UPI.
Level 1 fund gives you a buffer time to think your plan of action.
Level 2
The money you put in a stable and safe asset like a fixed deposit (FD).
This is a subset of the emergency fund that may not be instantly required but is good to have. So, it can be parked in an asset that gives better returns than a savings account. It can generate some passive interest income.
You may use an FD from a normal bank or from a Non-Banking Financial Company (NBFC). But remember that this should not be a tax saver FD as it has a lock-in period of 5 years.
Normal FDs can be prematurely withdrawn with a small penalty on the interest rate. For example, if you booked an FD at 7% and prematurely withdrew the money before its tenure, you will end up getting a lower rate, say 6% interest only. You can do it online and get the amount credited to your account.
Also, note that the returns from an FD are taxed as per your income tax slab. So, if you withdraw the amount, you must be mindful that you will have to pay the tax on your interest.
One may think of keeping another 3–6 months of expenses here.
FDs from registered Public/Private banks are insured for up to 5 L in amount. So, it’s pretty safe and stable.
At the time of writing this article, most banks provide FDs at 6% to 7.4% rates. If you want a bit higher interest rates, you can go with parking in FDs with “Small Finance Banks (SFBs)”. These are a bit different from your usual banks, but these FDs are insured too. You can expect rates of up to 8.5% here.
Another option is an NBFC-based FD. These are more risky and not insured and, hence, might not be good if your risk profile is low. Returns can be higher than SFBs.
If you are completely new to all these terms, you can search online for various banks and companies in India and go to their official websites to explore the FD options that they provide. Some groundwork is definitely needed before you decide, especially with SFBs and NBFCs.
In our example, the person may park another ~3 L in an FD.
Level 3
To maximize your safety net and plan for long periods of distress — say, when you take a career break or be in an active job search for several months, you will eventually need more money.
Or when there is a medical emergency to take care of, above and beyond your health insurance (if your personal health insurance isn’t ready or the one from your company got invalidated because you got laid off).
That’s where level 3 comes in. In most cases, you may never need it. So, you can pick assets with a more long-term growth objective.
Three interesting asset classes to consider here are bonds, digital gold, and debt mutual funds. Debt mutual funds are easier, more liquid to manage, and more secure compared to bonds. They are also more stable than gold.
You can explore bonds if you are really interested (make sure to check about the ease of getting your money back prematurely in time of need). For most practical purposes, debt MFs can be used.
You may expect anywhere between 7% to 11% annual returns in debt funds. Returns here can vary a lot based on the duration of investment and interest rate cycles. In many cases, the returns can be similar to SFB FDs.
You can visit any mutual fund investing platform to filter and compare different debt funds that fit your needs.
Three important things to note:
- You may go with a “Direct Growth” mutual fund, which implies that there are no agent commissions and any dividends related to the fund are reinvested into the fund itself.
- Look for this term called “expense ratio”. Ideally, you may pick a reputable fund with a low expense ratio — the fund house's charge for managing your money.
- Every mutual fund will have an “exit load,” which is the amount of charges levied by the fund house when you withdraw your money. You may want to look at funds that have zero or NIL exit load over long periods. Exit load is often a small percentage when you withdraw under 15 days or so. For money parked for longer durations, it is generally NIL.
I prefer the doubling-down approach to decide how much should be parked in the level 3 subset of your emergency fund.
Twice the amount in your level 1 and level 2 funds.
For our example, it would be another 6 L parked in debt mutual funds. You can pick 2 to 3 funds and split the amount across them too.
Alternatively, you can split equally between debt funds and digital gold (because buying, selling, and managing is much better than physical gold + no making or storage charges).
Note that Gold can give higher returns but is more volatile in nature.
How to save?
For our example of a person having 50K INR monthly expenses, their emergency fund could look something like this — 3 + 3 + 6 = 12 Lakhs INR.
With this kind of emergency fund, you can handle most types of scenarios. If you take a career break or get laid off, you can easily manage your living expenses (for several months to over more than a year).
Enough time, buffer, and headspace to live more freely and intentionally.
If your monthly living expenses are only 30K INR, then your fund would be — 1.8 + 1.8 + 3.6 = 7.2 Lakhs.
As you grow older and your expenses increase, you will have to adjust your funds too. These funds will also passively grow with time, offsetting some changes.
But how do you even save this much amount?
In a previous diary entry, I talked about leveraging compounding by investing more in equity mutual funds early in life. So a natural question would be how and where you put the money when you get your first job and start earning?
One should be clear that equity as an asset is not for short-term or emergencies. At the same time, starting to accumulate that corpus early in life can be game-changing, but not before you plan your emergency fund.
Let’s take an example to explore how to plan.
Let’s say 50% of your salary goes into your expenses. The other 50% is left for planning.
When building your level 1 and 2, you can be more aggressive towards the emergency fund — say 40% into level 1 and 10% to equity MFs.
When you complete your level 1 goals, you can keep 40% into level 2 and then 10% in equity MFs.
After your level 2 goals are met, you can more gradually invest in level 3. You may think of 25% into debt MFs and another 25% into equity MFs.
Once level 3 goals are met and your total emergency fund is ready, you can increase your equity investments to, say, 40%. You may not want to invest all your savings in equity, even at this stage.
It can be valuable to keep some savings aside (say 10%) as “reserve cashflows,” which are essentially extra savings in your account that can be used for some interesting opportunities when markets crash someday and when you want to buy the dips at lower prices.
Reserve cashflows can also be used to make random one-time purchases of things you want, like upgrading your lifestyle or buying stuff that falls outside of your usual expenses. This way, you can buy things without compromising your portfolio.
To summarize, your income can be split as below:
— Phase 1: 50% expenses + 40% in emergency funds + 10% in equity funds.
—Phase 2: 50% expenses + 25% debt MFs + 25% equity MFs.
—Phase 3: 50% expenses + 40% equity MFs + 10% reserve cashflows.
Based on how much % of your income goes towards expenses, these equations change. Also, you can use your annual bonuses to bulk invest and speed up the creation of the emergency fund so that you can focus more on the equity allocations.
Note that all the above ideas keep the context as for someone in their 20s who just started working.
Following these patterns, a good emergency fund can be built in about 2 years, all while building an equity portfolio in parallel.
My Personal Journey
Here’s what I actually followed with my own emergency fund.
Before I reveal the details, please remember that this diary is only for educational purposes. You have to do your due diligence and analysis based on your unique context and goals before making any decisions.
At the time of writing this article, I split my emergency funds across a savings account (level 1), an FD at Federal Bank (level 2) (at ~7% returns), and two debt mutual funds that have given me returns at ~8% and 7% (yearly) each.
Initially, I did not plan well, which delayed the creation of a good emergency fund. When I started learning about the intricacies of personal finance planning, I understood why it was important and prepared accordingly.
Prior to having set up my emergency fund, most of my savings were lying idle in my current account, earning an interest rate of 3%, completely eaten by inflation.
Better late than never.
I write this diary and share my experiences partly to help others reflect and plan early and better than me.
At the time of writing this, I am planning to move the Federal Bank FD into a Small Finance Bank FD sometime soon, as I can expect higher returns there.
I also want to move my quant liquid fund into some other debt scheme that has > 8% returns. However, as of now, I am not touching it because I invested in these funds before the rules of taxation for debt funds have changed.
In 2024, debt fund returns are taxed directly as per your income tax bracket. However, in 2022, when I made the investment, they were offered a lower tax rate of 20% along with an “indexation benefit” after 3 years of investment, which basically decreases the tax further. Since I invested in that calendar year, those rules apply to these funds.
All new investments will follow the newer rules.
I have personally not invested in digital gold yet and hence didn’t talk much about it.
That’s pretty much everything to cover.
A summary in a single line — plan for an emergency fund that covers up to 2 years of your expenses and park those funds in instruments like Savings accounts, FDs, digital gold and debt MFs.
Until next time :)
