How to build an emergency fund? Alternatives of saving account.

What is an emergency fund and why it is important?

To put it in a simple language, there could be an unexpected expense for which you need money. Or an event like COVID which can impact your businesses or job. In that case, if you would need money to manage your expenses like EMIs, home rent, groceries, etc. And if you don’t have an emergency fund then you might need to break your investment or end up borrowing money.

Hence, to avoid such a situation you should have an emergency fund of 6-9 months of your monthly expense. For example, if your monthly expense is Rs 50k then you should have an emergency fund of Rs 3-4 lakh.

Now the biggest question is - Where to park money to build this emergency fund?

So the 1st option is either to keep the money in cash at home or in the savings account. But the problem with cash or saving accounts is a poor return. You don’t get any return with cash at home. And the savings account interest rate is in the range of 2.5%-3.5%. This is even lower than the inflation rate which is around 5%. So if you keep money in cash or in saving account then your money is shrinking. So your effective return i.e. real return after considering inflation is negative. 
Now you might think of alternatives like a public provident fund or various Post office saving schemes, etc. But there is a problem. These options have a lock-in period. For example, PPF has a lock-in period of 15 years. So if you need money now then you won’t get it. And this is the most important criteria to build an emergency fund. Your emergency fund should have the liquidity so that you can access the money whenever you need it.

This means your emergency fund should satisfy 2 criteria - 
  • It should have enough liquidity to access the money whenever you want. 
  • It should provide a decent return of more than 5% where it at least beat the inflation.
Hence, we are now left with 2 options- FD and Debt Mutual Fund. So what is the difference between FD and Debt Mutual Fund? Let’s look at it in detail:

The benefit of FD:

  • Returns are fixed: You get a fixed return without any fluctuation. For example, if you have taken an FD for 6% then you will get a 6% return irrespective of the economic situation.

Let’s look at the latest FD rates from major banks in India:

So more or less, the interest is in the range of 2.5% to 5.5% except for IDFC bank which has an interest rate of up to 7%. Please note that this interest is applicable to a person below the age of 60 years. Here, range means the interest rate would vary based on FD duration. For example, SBI bank's highest interest is 5.4% but this is applicable only when you make an FD for 5-10 years. If you make an FD for 1 year, the interest rate is 5.1%.

But there are a few disadvantages of FD:
  • There is an exit load on pre-mature withdrawal. For example, if you make an FD with HDFC bank for 1 year at a 5.1% interest rate and you need money after 6 months then there would be an exit load of 1%. It means, your effective interest would be 4.1%.
  • Interest is taxable as per the income tax slab. For example, if you make an FD with HDFC bank for 1 year at 5.1% and if you fall under the 30% tax bracket then you would need to pay 30% of 5.1% as tax. For example, let's say you made an FD of Rs 1 lakh then you will get Rs 5,100 as interest by the end of 1 year. But you would need to pay a tax of 30% on Rs 5,100 which would be Rs 1,530. So your effective return post-tax would be 3.57% which is lower than the inflation rate.
Now there are some NBFCs and small finance banks which are providing higher returns.
Please note that under the latest “Deposit Protection Scheme”, depositor money is protected up to Rs 5 lakh. It means, if the bank fails to repay the customer, the depositor would still get up to Rs 5 lakh. But this scheme is applicable only to commercial public banks and small finance banks. It is not applicable to NBFCs.

Now some of you want to explore the debt mutual fund category. So let’s talk about the Debt Mutual Funds:

What is a debt mutual fund?

It is a type of mutual fund where the fund manager invests the money in bonds.

What is a bond? 

It is a loan to a company or government that pays investors a fixed return.

So debt mutual funds invest in multiple bonds of various companies.
But there are many categories of debt mutual funds. For example, you have an overnight fund, liquid fund, money market fund, ultra-short duration fund, banking, and PSU debt fund, gilt fund, credit risk fund, etc.
Please note that the returns from debt funds are not fixed. It would vary from category to category and scheme to scheme within each category.
When it comes to building an emergency fund, you should invest in a debt fund with low volatility. Obviously, you don’t want to take too much risk with your emergency fund. So debt funds that invest in instruments of shorter maturity are less risky funds.
I want to especially focus on 3 categories.
  • Liquid fund
  • Ultra-short duration fund
  • Money market fund
All these categories have very low volatility as they invest in instruments with a maturity of less than 1 year.

1. Liquid fund: This is the most popular category of debt fund for emergency purposes and my personal favorite. Now let’s talk about the risk vs return:
Risk is very low. The major reason is they invest in bonds and money markets with a maturity of less than 3 months. You can look at the NAV movement of any liquid fund and it would be a straight line signifying almost negligible volatility in return.
For example, you can see the Axis liquid fund NAV movement on the screen for the last 1 year. It has a straight line with a slight dip and it again recovered. It shows the volatility is negligible and hence the risk is negligible.

If you look at the portfolio of Axis liquid fund, the investment is in government-backed securities and low-risk instruments.

Always ensure that the investment is either government-backed securities or low-risk instruments.

If we talk about the returns, the returns are in the range of 5%-6%.
You can explore all the schemes under the liquid fund category with their NAV movement, returns, and portfolio details on moneycontrol or valuereserach website.
Another advantage of liquid fund is “no exit load” on withdrawal after 7 days. So unlike your FD where there is a exit load of around 1% on pre mature withdrawal, there is no exit load with you withdraw your money from liquid funds after 7 days.
But if you need a slightly higher return than a liquid fund, then you can consider ultra short term fund.

2. Ultra-short duration fund: If we talk about the risk vs return, the risk is again low with ultra-short duration fund because they invest in instruments with a maturity between 3-6 months.

Although, there is a small dip but it has again recovered. If we talk about the return, the returns in this category are in the range of 6%-7%. Exit load on ultra-short duration fund would vary from scheme to scheme. Some might have an exit load while some do not. For example, there is no exit load on the SBI magnum ultra-short duration fund.
3. Money market fund: If we talk about the risk, the risk is again low in the money market fund category as the investment is in instruments with maturity within 1 year.

If you look at the last 1 year NAV movement of ICICI pre-money market fund, you can see that there is a straight line with small volatility in between. But it has again recovered. So this category is again low risk.

If we discuss the returns, the returns are in the range of 7%-8%. Again there is no exit load on most of the schemes from this category.

Taxation: If you withdraw money within 3 years, you need to pay tax as per your income tax slab. If you keep money for more than 3 years, there is an income tax of 20% with indexation benefit. So if you are someone who falls in the 30% tax bracket and wants to keep the money for more than 3 years, then debt mutual funds have much lower tax as compared to FD.

Conclusion: So in this article, we discussed the alternatives to saving accounts. Do you prefer FD or debt funds for mutual funds? Do let me know in the comment box. 

Did you like this article? If yes, I would strongly recommend enrolling in the complete course on money management where you will learn every aspect of money management. This would be one of the best investments of your life.

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