We can’t see the future and we aren’t able to forecast it accurately. It is important to have some money in reserve to deal with unexpected surprises and shocks. This is similar to how ants save money for rainy days so they can eat enough food even if they don’t have the means to go out and fetch it.
Also known as “contingency funds”, emergency funds are money that we keep in reserve to avoid our goal-based planning being ruined or defaulted by a sudden turn of events. This money is used to ensure that you do not have to borrow money from close relatives or take out a loan from financial institutions. These funds should only be used for emergency situations that are unexpected. They shouldn’t be used for overruns, budget problems or for other reasons. This could be a sudden job loss or a serious illness or accident.
Two main characteristics determine the utility of money we earn in our daily lives: liquidity and returns. You must keep these key features in mind when looking to reap the greatest benefits from your money. With contingency funds the priority is placed more on liquidity than the return. Even so, the goal is to obtain as low risk returns as possible on this money.
To be able to quickly access funds when you need them, it is advisable to keep emergency funds in liquid funds or ultra-short term debt funds. However, investing emergency funds in fixed deposit might reduce the returns (if it is broken too early). It may also be tax-inefficient if the need for emergency loans from mutual funds is not apparent within three years. Because long-term capital gains on debt mutual fund does not cover fixed deposits in its scanner, this is why it may be tax inefficient. Financial planning is about investing in a good lump sum amount in liquid or short MFs, or SIPs. This helps to prepare one for the future. To overcome unexpected bumps in your financial journey, it is a good idea to have emergency funds.