Strategies For Investing Your Rainy Day Fund Wisely

An emergency fund is a safety net for life's unexpected events, such as medical emergencies, home repairs, or travel expenses. It is recommended to have three to six months' worth of living expenses in an emergency fund, but this can be challenging when savings accounts offer low-interest rates. While it is generally advised to keep emergency funds in a safe, low-risk, and highly liquid account, investing your emergency fund can be a better option to beat inflation.

- Money market accounts: These accounts offer slightly higher annual yields than traditional savings accounts and provide easy access to funds.

- Certificates of deposit (CDs): CDs offer higher interest rates than savings accounts but may have early withdrawal penalties. Building a CD ladder with staggered maturities can provide liquidity and help avoid early withdrawal fees.

- Low-risk mutual funds: Money market mutual funds invest in cash and short-term debt securities, offering easy liquidity. Short-term bond funds provide higher yields with slightly higher risk but tend to remain stable, allowing you to sell shares without significant losses in an emergency.

- Home equity: A home equity line of credit (HELOC) can be a source of cash in an emergency, but it is important to have it in place before retirement when income is higher and credit is good.

- High-yield savings accounts: These accounts offer higher interest rates than traditional savings accounts and are federally insured, making them a good option for emergency funds.

- Cash management accounts: These accounts combine features of checking, savings, and investment accounts and are offered by non-bank financial institutions.

- Money market funds: These funds invest in low-risk, short-term securities like treasury bills and are highly liquid.

- Taxable brokerage accounts: These accounts can be used to invest your emergency fund, but you may incur capital gains taxes when selling investments.

- Roth IRA: You can withdraw contributions tax and penalty-free, but it may have contribution limits and more cumbersome paperwork.

Money market accounts

Money market funds, offered by companies like Vanguard, are slightly different. These funds invest in low-risk, short-term securities like Treasury bills and are highly liquid mutual funds, allowing for easy access to your money. However, they are not FDIC-insured, so there is a slight difference in risk compared to money market accounts.

Overall, money market accounts and funds are a good option for those seeking higher returns on their rainy day funds while maintaining relatively low risk and good liquidity.

High-yield savings accounts

A high-yield savings account is a great option for your rainy day fund, offering a good balance of accessibility and returns.

Firstly, high-yield savings accounts are easily accessible, allowing you to withdraw money quickly and without fees (up to a certain limit per month). This is an important feature for a rainy day fund, as you'll want to be able to access your money in an emergency.

Secondly, these accounts offer higher interest rates than traditional savings accounts, allowing your money to grow faster over time. For example, you can earn an average of 3-4% APY from many high-yield savings accounts, compared to around 0.3% APY from a traditional savings account. This helps to offset inflation and means your money is earning money.

Thirdly, high-yield savings accounts are considered low-risk. Money in these accounts is typically insured, for example, by the FDIC in the US, which protects your savings up to a certain limit.

When choosing a high-yield savings account, consider using an online bank, as these often offer higher interest rates. However, keep in mind that with an online-only account, you won't be able to access your funds at a branch location, and some methods of withdrawal may take several days.

While a high-yield savings account is a great option for your rainy day fund, it's important to note that there are other alternatives available, such as money market accounts and certificates of deposit (CDs). These options also offer various benefits in terms of accessibility, returns, and liquidity, so it's worth considering your specific needs and comparing different options before making a decision.

Certificates of deposit (CDs)

A certificate of deposit (CD) is a type of savings account that holds a fixed amount of money for a fixed period of time, ranging from 3 months to 10 years. In exchange, the issuing bank pays interest. When you cash in or redeem your CD, you receive the money you originally invested plus any interest. CDs are considered to be one of the safest savings options. A CD bought through a federally insured bank is insured up to $250,000.

CDs generally pay higher interest rates than savings and money market accounts. They are a safer and more conservative investment than stocks and bonds, but offer lower growth opportunities. You can find CDs at banks, credit unions, and brokerages.

The interest rate on a CD is usually fixed, although there are variable-rate CDs that could earn a higher return if rates rise. With a fixed-rate CD, you know exactly how much you'll earn by the end of the term, but you could lose out if rates rise after you're locked in. The longer the term, the higher the interest rate will be.

CDs are a good option if you have cash that you don't need now but will want within a few years. They can also be a good choice if you want to invest some of your savings more conservatively, with lower risk and volatility than stocks and bonds.

One downside of CDs is that your money is locked in, and you will be charged a penalty if you withdraw your funds early. However, this can also be seen as a benefit, as it deters spending. Inflation can also eat away at the value of money locked in at a fixed rate.

You can create a CD ladder by investing in multiple CDs with different maturity dates. This increases liquidity and helps you avoid or minimize early withdrawal penalties. Some banks also offer no-penalty CDs, which allow you to withdraw your money without sacrificing any interest, although the interest rate may be lower than a regular CD.

Low-risk mutual funds

Invesco India Arbitrage Fund

This fund has provided 7.17% annualised returns in the past three years and 6.11% in the last five years. The minimum amount required to invest via lump sum is ₹1,000, and via SIP is ₹500.

Tata Arbitrage Fund

The Tata Arbitrage Fund has delivered 6.79% annualised returns in the past three years and 6.17% in the last five years. The minimum amount required to invest via lump sum is ₹5,000, and via SIP is ₹150.

Bank of India Overnight Fund

This fund falls under the Debt category of mutual funds.

Axis Overnight Fund

The Axis Overnight Fund has generated 5.84% annualised returns in the past three years and 4.88% in the last five years. It falls under the Debt category of Axis Mutual Funds.

Mirae Asset Overnight Fund

The Mirae Asset Overnight Fund has delivered 5.84% annualised returns in the past three years and 4.92% in the last five years. The minimum amount required to invest via lump sum is ₹5,000, and via SIP is ₹99.

Kotak Equity Arbitrage Fund

The Kotak Equity Arbitrage Fund has yielded 6.96% annualised returns in the past three years and 6.06% in the last five years. The minimum amount required to invest via lump sum is ₹100, and via SIP is ₹100.

Edelweiss Arbitrage Fund

The Edelweiss Arbitrage Fund has generated 6.91% annualised returns in the past three years and 6.1% in the last five years. The minimum amount required to invest via lump sum is ₹100, and via SIP is ₹100.

Asset Allocation

Risk-Reward Ratio

These funds minimise or eliminate investor risk by placing assets in low-volatility segments. However, this also means that the likelihood of earning high returns is lower.

Tax Implications

Holding low-risk mutual funds for more than three years results in long-term capital gains taxed at a flat rate of 20% with indexation benefits. Selling assets before the three-year mark will add returns to the investor's yearly income, taxed per the applicable slab rate.

Suitability

These funds are suitable for investors with a short-term investment horizon, typically less than a year. They help achieve short-term financial objectives and act as a supplementary source of income.

Considerations for Investors

When considering low-risk mutual funds, it is essential to evaluate financial goals, investment time horizon, and risk appetite. It is also crucial to study the fund's past performance, expense ratio, and credit rating to make a well-informed decision.

Credit cards

If you do use a credit card to cover an unexpected expense, try to pay off the balance as soon as possible to avoid accruing interest. It's also a good idea to shop around for a credit card with a low interest rate and no annual fee.

In general, it's best to use your rainy day fund to cover unexpected costs rather than relying on credit cards. This will help you avoid debt and maintain your financial stability.

Frequently asked questions