FD Or Debt Funds? Where Should You Invest To Create An Emergency Fund?

A sudden job loss, diagnosis of a serious illness of self or a family member, an accident, or any other unexpected incident can turn life upside down without warning and destabilise life. The unpredictability of such incidents demands preparation. Experts suggest keeping a portion of your money aside for emergency purposes. But where should you keep it? It should be in instruments that can anytime be converted into cash.

Maintaining an emergency fund not only gives confidence to face any unexpected situation but also resilience to come back to normalcy after such incident happens.

Charu Pahuja, Director & Chief Operating Officer, Wise Finserv, says, “Emergency money should be easy to reach. That matters far more than the return it earns. When a need arises, the money should be available the same day or within a short window. Safety of capital and simplicity are non-negotiable.”

As equity, real estate, gold, etc., require a long-term investment view, for emergency fund creation, one can invest in bank FDs or debt mutual funds. But if these are compared, which could be the better option: FD or a debt mutual fund?

For this, one needs to consider the following points:

Premature Exit

Banks charge a premature withdrawal penalty, and the mutual fund may have an exit load for withdrawal before a minimum period stipulated under the scheme.

For those who prefer FDs, Pahuja says, “Many conservative investors prefer fixed deposits because they are familiar with them. However, problems arise when an FD is broken before maturity. In linked or sweep-in FDs, premature withdrawal often leads to penalties. For example, if an FD booked at 7 per cent is broken after just two months, the bank may recalculate interest at the short-term rate and apply a penalty. The outcome is lower returns and reduced flexibility at a time when money is urgently required.”

Although earning returns is not the aim of emergency funds, there is no harm in getting higher returns if possible. Therefore, experts suggest considering the liquid funds and arbitrage funds under the debt fund category of mutual funds.

“Liquid and overnight mutual funds handle this situation more smoothly. Several fund houses allow instant redemption, often up to Rs 50,000, with money credited within minutes. Importantly, in liquid and overnight funds, annualised returns are not distorted by short holding periods, unlike in FDs. This makes them far more practical for emergency use,” says Pahuja.

Banks typically charge 0.50 per cent to 1 per cent penalty on premature withdrawal, whereas the exit load in case of liquid and arbitrage funds could be much lower.

Anooj Mehta, Vice President, Partner Success at 1 Finance, says, “Exit loans on liquid funds typically range between 0.0045 and 0.0070, with redemption spreads between 1 and 6 days. From the 7th day onwards, the exit load becomes nil on redemption of liquid funds. Exit load on an arbitrage fund is 0.25 for up to a 15–30-day redemption period.”

As returns for both FDs and these funds hovered in the range of 6 to 8 per cent over one year, it is important to consider the exit charge when parking funds with the goal of any time withdrawal.

Another crucial factor to consider is tax.

Tax Bracket

Pahuja suggests, “Interest earned on bank deposits is taxed every year, even if the FD has not matured or the money has not been withdrawn. This creates a regular tax outflow. Debt mutual funds work differently. Tax is payable only when units are redeemed.”

However, the return from both FD and liquid fund is taxed at slab-rates of the investor.

Note that the taxation was different for the debt mutual fund until March 31, 2024. If investment in a debt fund was kept for more than 24 months, a long-term capital gain tax applied at 12.5 per cent. However, this rule was changed in Budget 2023. The new rule made gains from the debt fund taxable at slab-rates irrespective of the holding period. The new rule is effective from April 1, 2023.

But arbitrage funds are considered as equity funds for taxation purposes, and thus, better off in post-tax returns.

Mehta says, “For those in lower income tax brackets, FDs are a suitable option, as the interest is taxed at your applicable income tax slab rate. However, if you fall into the highest tax bracket, Arbitrage Funds are more efficient. Since they are treated as equity assets, the Long-Term Capital Gains (LTCG) tax is only 12.5 per cent, compared to the 30 per cent slab rate applicable to FDs and debt funds.”

What Should Be Your Strategy?

“If the horizon is less than 7 days, liquid funds are better than FD; despite the exit load, there are still returns. As FDs only return principal without any interest if withdrawn within 7 days. For anything above 1 month of tenure, arbitrage funds can be considered, as most of them have exit loads ranging from 15 to 30 days. FDs usually apply the penalty to the rate, effectively reducing the effective return in the short term,” Mehta advises.

However, unlike FD, liquid or arbitrage funds do not guarantee a return.

Pahuja suggests, “A layered approach works best and keeps things organised. Money needed for immediate expenses covering one to two months should sit in a savings account or a sweep-in FD. Funds meant for short-term emergencies over the next three to six months can be parked in liquid or overnight mutual funds. This structure ensures that money is always available without forcing compromises.”

Mehta suggests some exposure to arbitrage funds as well. “Keep a portion of your emergency corpus in a Savings Account or FD with a Large Bank for instant access and park the remaining in Arbitrage Funds. With T+1 redemption cycles, Arbitrage Funds are highly liquid. However, for very short durations, one should avoid Arbitrage Funds due to exit loads and minor volatility; FDs or Liquid Funds are better suited for such immediate needs.”

So, use a hybrid approach to create an emergency fund using FDs, liquid funds, and arbitrage funds, and create a cushion against any unexpected financial blow.