Posted On Wednesday, Aug 06, 2014
It’s that time of the year when stores spruce up their display with umbrellas, rain coats and street vendors switch to selling rain proof wares. Monsoon is a season loved by a lot of people but it does make us frown if it leaves us stranded at some place or when it pours on a clear day and we are without the rain gear. In cities like Mumbai it is notorious for disrupting transportation and upsetting daily commuters.
Unlike the seasonal monsoons in the country whose arrival timings the Met department manages to predict with reasonable accuracy a rainy day for one’s personal finance takes the best of seasoned investors by surprise unless they were prepared with adequate rain gear at all times.
A rainy day for finances
No matter how prudent a planner we may be with finances as with our other life responsibilities there can be those unexpected expenses, large or small, which can take on us unawares. Often these emerge from normal wear and tear that requires fixing or perhaps more serious, like an accident. At times it could be the health issue of a family member. It might be a case of job loss or some situation that keeps one out of employment temporarily.
Apart from the emotional woes these bring all these can give a set back to our finances as well unless we have a cushion to fall back on. An emergency fund could be the cushion here – one that we can run to and withdraw money from any moment without facing penalties (and adding to financial distress!). When caught in a rainy day, it will not help that we are regular investors and can boast of a robust portfolio built over many years, unless we have adequate liquidity or cash reserves to bail us out of the moment. We may end up redeeming from long term investments meant for some specific goals to meet the emergency situation.
Creating your emergency fund
Now preparing the rainy day fund is not as motivating as investing for the other big goals, probably because we inadvertently assume these things happen to others but they’re not much likely to come our way. Nevertheless building an emergency fund should be a priority for everyone who has financial responsibilities.
While building up such an emergency fund there are two aspects to consider:
i. How big a corpus is big enough
ii. What is the best savings avenue for the rainy day fund
i. Financial planners commonly recommend putting away about 3-6 months’ expenses in your emergency cash reserve. For the single ones with no debts 3-6 months’ expenses may be good enough whereas for the married, those having kids and/or EMIs running, about 6-12 months’ expenses may be good to start with. This rule is not a hard and fast one; depending on individual financial situations and responsibilities one may have to alter the size of their emergency fund.
ii. Now coming to suitable avenues for your rainy day fund. Since emergencies can strike any time your emergency fund should be accessible any time too or at the most in a day’s call.
The obvious avenue that comes to mind suiting this requirement is a savings deposit. Savings deposit offers great liquidity; you can withdraw funds from an ATM too.
Fixed deposit could be considered due to higher interest rate they offer but the penalty charge for premature withdrawal is a negative point.
However there is another option that lets you save for the rainy day, with the possibility of earning greater returns while providing sufficient liquidity– liquid funds. Liquid funds are mutual fund schemes that invest in very short term debt securities, typically securities with maturity of maximum 91 days. Consequentially their risk level is low compared to other funds.
Liquid funds for your rainy day fund
Returns from liquid funds are market linked; they move according to the yields of the CDs, CPs, T-bills and other liquid securities which such schemes invest in. Their returns are generally higher than that on savings account which has been at the 4% level since a long time. The table below depicts historical returns from liquid mutual funds.
|Index||1 Year (%)||2 Year (%)||3 Year (%)||4 Year (%)||5 Year (%)||7 Year (%)||10 Year (%)|
|Liquid Funds Performance||9.51||9.11||9.14||8.62||7.69||7.71||7.19|
Liquid funds attract capital gains tax, which is 20% with indexation in case of long term capital gains where investment is held for 3 years or more (based on new tax rates for redemptions made after 10th July, 2014). In comparison savings deposit attracts tax on interest according to investor’s tax slab above the threshold interest of Rs 10,000. Thus for investors, especially those in the higher tax slabs, a liquid fund makes better financial sense than savings deposit or fixed deposit for their emergency fund.
As far as liquidity is concerned the redemption proceeds from liquid schemes are available on the next business day. There is no minimum investment duration and usually they do not charge exit load.
Here’s the sum of the comparison of Liquid funds vis-à-vis Savings deposit for your rainy day fund
|Liquid funds||Savings deposit|
|Returns||Market linked; 1 yr return 9% 1||Fixed; 4% 2|
|Taxation||Capital gains tax applicable||Interest taxable at applicable tax slab|
|Liquidity||Available next business day||Available instantly|
|Risk||Market risks involved||Risk perceived to be zero|
|Principal Amount||Not secured||Secured as per the limits mentioned in the Banking Regulations|
Start right away
Creating an emergency corpus should be the first task to be undertaken once one starts earning, even before one ventures into investments for the long term. However, if you have not built it yet now is the best time to do it.
To begin building this corpus one might have to cut back here and there on some monthly expenses. If you find yourself with a windfall amount of money this could be used for building the emergency fund without upsetting your regular cash flows. Those who find absolutely no scope for this might have to temporarily squeeze their regular investment outgo a little just until the emergency reserve is comfortably large enough; however this is an extreme case.
Liquid funds may not be suitable to work as a complete substitute for your savings account however you may consider them to park a part of your savings meant for your emergency rainy day fund. You can find out more about Quantum Liquid scheme and if you’d like one of our executives to get back to you please indicate this in the contact us form provided on the website.
This article explains the basic concepts of the usefulness regarding fixed deposit and liquid fund and is not meant to serve as a recommendation for investment. Do consult a financial advisor for your investment decisions.
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