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Financial Safety Net Showdown Debt Mutual Funds or Bank FD's for Your Emergency Fund

One of the primary dilemmas we face is identifying our emergency fund. Once it’s recognized, the question becomes where to securely park it, not invest. Before delving into the merits and demerits of these two financial tools, let’s first clarify their intended purpose.

Showdown

The Purpose of an Emergency Fund Understanding the objective of an emergency fund is crucial for making the right choice. When it comes to emergency funds, two key factors are of paramount importance:

  1. Accessibility: Your emergency fund should be readily accessible without any hassles or waiting periods. Liquidity is the top priority when choosing a suitable option. Your emergency fund should be available 24/7, without exception.
  2. Safety: It should be in the safest possible place. While some individuals may seek returns on their emergency fund, prioritizing returns over safety could lead to negative results, defeating the purpose of having an emergency fund. Safety should be your primary concern when selecting the right financial product.

Debt Mutual Funds vs. Bank Fixed Deposits (FDs) – Where to Park Your Emergency Fund? Keeping the two essential aspects in mind, let’s explore the advantages and disadvantages of using Debt Mutual Funds and Bank FDs for your emergency fund:

Debt Mutual Funds: Debt mutual funds encompass various categories, with Overnight Funds being the lowest-risk option. These funds involve holding securities for just one day, which makes them the least risky within the realm of debt funds. Choosing the “best” Overnight Fund is not necessary, as all Overnight Funds adhere to the same one-day holding strategy. Presently, there are 34 Overnight Funds available. Avoid investing in Overnight ETFs due to concerns over liquidity caused by low trading volumes.

You can select any of these funds for investment, without being overly concerned about their past year returns. These returns may appear impressive due to inflation and rising interest rates, but, as previously emphasized, safety is the priority. Therefore, we recommend Overnight funds for your emergency fund.

Another category of debt mutual funds suitable for parking your emergency fund is Liquid Funds. Liquid Funds typically invest in debt securities with maturities of up to 91 days, making them less volatile compared to other types of debt funds (although slightly riskier than Overnight Funds).

However, it is important not to blindly invest in Liquid Funds, as there have been instances in the past where they performed poorly due to fund managers taking excessive risks. Therefore, before choosing a Liquid Fund, it’s essential to assess the fund’s portfolio. In India, there are currently around 36 Liquid Funds available. As with Overnight Funds, it’s advisable to avoid ETFs in this category.

While my preference is the Parag Parikh Liquid Fund or Quantum Liquid Fund (not QUANT), you are free to choose the fund that suits you. Remember that not all Liquid Funds are equally safe; assess the fund’s portfolio before making your decision. Avoid experimenting with other categories of debt funds to minimize risks. Stick to Overnight and Liquid Funds for your emergency fund.

Safety of Debt Mutual Funds: Overnight Funds are virtually risk-free, but the safety of Liquid Funds depends on the specific fund you choose.

Liquidity of Debt Mutual Funds: Liquidity can be a concern with both Overnight and Liquid Funds. Some funds offer instant redemption of up to Rs. 50,000 or 90% of your portfolio (whichever is lower) per day. If you need to withdraw more than this limit, you may have to wait for the standard redemption process, which can take 1-2 days.

Taxation of Debt Mutual Funds: As of April 1, 2023, returns from debt mutual funds are taxed based on your income tax slab. Therefore, there is no significant tax advantage to investing in these funds.

Bank Fixed Deposits (FDs): Bank FDs are straightforward and easily managed financial products, making them a preferred choice for parking your emergency fund. However, consider the following points:

Choose a trustworthy bank rather than chasing higher returns. Avoid co-operative banks, small finance banks, or non-banking financial companies (NBFCs) for your emergency fund.

Book your FDs online for easy access and liquidity.

If your emergency fund is substantial, consider splitting it into multiple smaller FDs (e.g., if your fund is Rs. 6 lakh with monthly expenses of Rs. 1 lakh, create six FDs of Rs. 1 lakh each). This can reduce premature withdrawal penalties.

If your emergency fund exceeds the maximum insured amount of Rs. 5 lakh, consider investing the surplus in your spouse’s name.

Utilize sweep-in FDs if your bank offers this feature.

If you have a home loan overdraft (OD) account, such as SBI MaxGain or Bank Of Baroda’s “Baroda Home Loan Advantage,” consider parking your emergency fund there, as it can be more cost-effective.

In summary, the primary purpose of parking your emergency fund is to prioritize liquidity and safety. Taking these two factors into account, Bank FDs are the preferred choice over Debt Mutual Funds. However, the ultimate decision is yours, but always keep in mind the fundamental purpose of your emergency fund: quick and secure access to funds in times of need.

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