An adequate emergency fund comes to the rescue when you face a critical financial situation like a sudden job loss or a family emergency. This contingency fund, that should ideally be at least 6 months of your expenses, works like a cushion that helps you overcome afinancial crisis. However, it’s not a good idea to keep your entire emergency fund in a regular savings account due to its low returns. In the long-term, there is erosion in the value of your cash holding due to the impact of inflation. Keep a small portion of your emergency fund in cash holdings and the rest should be invested to get a return that should be higher than the prevailing inflation rate. So, high liquidity, accessibility and moderate returns should be the focus areas while choosing an investment instrument to build an emergency fund.
Many people keep their emergency fund invested in liquid funds or fixed deposits. But, if you have to make a choice, which one should one opt for and why? Let’s take a look at both investment products to understand their pros and cons.
Keeping emergency fund invested in fixed deposits
FDs allow investors to park their fund for a minimum of 7 days to 10 years or even more in some cases. FDs are usually of two types, i.e., cumulative FDs and non-cumulative FDs. Under cumulative FDs, the interest is compounded on a regular interval and the investor gets the maturity amount on the completion of the tenure. Therefore, the annualised yield is higher than the applicable interest rate. Non-cumulative FDs, on the other hand, allow interest rate credited on a regular interval, i.e., on a monthly, quarterly, half-yearly, or yearly basis. On maturity, the investor gets the refund of an amount equal to the principal investment. FDs can be created on request of the investors or if the investor has opted for a sweep-in FD, the amount above threshold in the linked savings account is automatically transferred to the deposit.
If you keep an emergency fund in an FD and break it before maturity, the bank is likely to levy a penalty of around 0.5% to 1% of the interest value. Do note that the prevailing FD rates across commercial banks are around 4% to 7.15% annually for tenures below 1 year and 5.5% to 7.75% annually for tenures greater than 1 year and up to 10 years.
As such, FDs allow you assured returns, therefore, it proves to be a good choice for a long-term emergency fund. Breaking it quickly in the face of an emergency through internet banking after losing up to 1% of the interest value isn’t a bad deal either. However, if the FD interest is more than Rs 10,000 (for non-senior citizen depositors) during the relevant financial year, the bank deducts a TDS at a 10% rate on such interest. If your income is below the taxable limit, you can avoid TDS by submitting Form 15G/H.You canuse FD laddering to invest for short and long-term emergency funds; thus you can opt for FDs for different maturity tenures and renew it upon maturity. During a financial emergency, you can break one or more FDs according to your fund requirement, thus keeping the other FD accounts undisturbed.
Keeping emergency fund invested in Liquid funds
Liquid funds are debt-oriented mutual fund schemes that invest the accumulated corpus in debt instruments with less than 91 days maturity. There is no premature withdrawal penalty if you exit from a liquid fund investment. The returns on liquid funds usually vary in the range of around 5% to 7.5% annually. However, the returns are not liable to any TDS. It’s easy to invest in liquid funds and you can redeem the fund anytime using the online applications.
So, Which one should you go for?
Interest on FDs is subject to TDS, whereas it’s not applicable to liquid funds. Income on FDs is taxed at the slab rate applicable to the investor -- even on long-term investments. On the other hand, liquid funds are taxed at an applicable slab rate for the short-term i.e., for investments below 3 years. If the investment period is more than 3 years, liquid fund returns are taxed at a 20% rate with indexation benefit. Also, the tax on liquid funds become applicable only after they are redeemed.
In terms of security, both FDs and liquid funds are safe, but FDs have a little edge with assured returns. Liquid funds, on the other hand, allow better tax efficiency and flexibility if the investor wants to withdraw the fund prematurely.
As such, conservative investors can prefer to invest their emergency fund in FDs. If the interest rate is expected to increase, investors may invest in liquid funds.
The ideal option would be to diversify the emergency fund investments in savings accounts, FDs and liquid funds. You may opt for allocating a portion of the emergency fund to FD laddering while investing the remaining amount in the liquid fund. Depending on your exposure to financial risk, you should opt for the right mix of investment instruments for liquid funds. When in doubt, consult an investment advisor before you make the final choice. (The author is CEO, BankBazaar.com)