Question: 26. I have built an emergency fund equivalent to 6 months of my living expenses (₹6 lakh) and parked it in a standard savings account earning 3.5% interest. With inflation at 6%, my fund is losing purchasing power. Should I move half of it to a liquid mutual fund which offers potentially higher returns (5-6%) but carries a slight risk?

As a diligent saver, you've taken a crucial first step by building an emergency fund equivalent to six months of living expenses (₹6 lakh). Parking it in a standard savings account earning 3.5% interest, however, does leave it vulnerable to inflation, which historically has been higher than your current earnings. While the latest Consumer Price Index (CPI) for India in August 2025 showed an inflation rate of 2.07%, the average inflation rate from 2012 to 2025 was 5.77%. This historical context validates your concern about your fund losing purchasing power over time.

The primary purpose of an emergency fund is to provide a financial safety net for unforeseen events like job loss, medical emergencies, or unexpected home repairs. Therefore, the core principles guiding its management are safety and liquidity. While higher returns are desirable, they should not compromise these two fundamental aspects.

Savings Account: The Foundation of Liquidity

Your current setup of keeping the entire ₹6 lakh in a savings account offers unparalleled liquidity and absolute capital safety.

• Pros:

  • Instant Access: Funds are readily available for immediate use, often 24/7, through ATMs, online transfers, or UPI.
  • Zero Capital Risk: The principal amount is completely safe and guaranteed by the bank (up to ₹5 lakh per bank under DICGC insurance).
  • Simplicity: Easy to manage and understand.

• Cons:

  • Low Returns: As you've noted, the 3.5% interest rate often falls short of even moderate inflation, leading to a real loss in purchasing power over time. Standard savings account interest rates typically range from 2.50% to 3.50% for balances up to ₹5 lakh with major banks.

Liquid Mutual Funds: A Step Towards Better Returns

Your consideration of moving half your emergency fund to a liquid mutual fund is a prudent step to seek potentially higher returns. Liquid funds are a type of debt mutual fund designed for short-term parking of funds.

• How they work: Liquid funds invest in highly liquid, short-term money market instruments like Treasury Bills, Commercial Papers, and Certificates of Deposit, with maturities typically up to 91 days. This short maturity period helps in minimizing interest rate risk.

• Pros:

  • Higher Potential Returns: They generally offer better returns (often in the 5-6% range, as you mentioned, or sometimes higher) compared to traditional savings accounts.
  • High Liquidity: You can typically redeem units quickly, with funds often credited to your bank account within 24 hours (T+1 settlement). Some funds even offer instant redemption for a limited amount.
  • Low Risk: While not entirely risk-free, they are considered one of the safest categories within mutual funds due to their investment in high-quality, short-duration instruments.

• Cons:

  • Not Risk-Free: Although low, liquid funds carry some risks:
    • Credit Risk: The risk that the issuer of the underlying debt instrument defaults. However, SEBI regulations limit exposure to risky assets and mandate investment in listed commercial papers, mitigating this risk.
    • Interest Rate Risk: While minimal due to short maturity, changes in interest rates can still slightly impact returns.
    • Negative Returns: In rare scenarios, liquid funds can deliver negative returns if the Net Asset Value (NAV) decreases.
  • Taxation: This is a significant consideration. For liquid fund units acquired on or after April 1, 2023, any capital gains (profit) are added to your total income and taxed at your applicable income tax slab rate, irrespective of the holding period. Dividends (Income Distribution cum Capital Withdrawal - IDCW) are also taxed at your slab rate. This is a key change from previous taxation rules where long-term capital gains enjoyed indexation benefits.
  • Minor Exit Load: Some liquid funds might impose a small exit load if redeemed within a very short period, typically 7 days.

Advisory Article: Actionable Steps for Your Emergency Fund

Given your situation, a balanced approach is often the most prudent for an emergency fund.

1. Split Your Emergency Fund:

   • Immediate Access (1-3 months' expenses): Keep a portion, ideally ₹1 lakh to ₹2 lakh (1-2 months of your expenses), in your savings account or a high-yield savings account. This ensures immediate liquidity for truly urgent needs without any redemption delays. Some small finance banks offer higher interest rates on savings accounts (e.g., up to 7-8% on higher balances), which could be a better option than your current 3.5% for this portion.
   • Enhanced Returns (Remaining 3-5 months' expenses): The remaining ₹4 lakh to ₹5 lakh can be strategically moved to a well-chosen liquid mutual fund. This portion is still highly liquid but aims to generate better returns, helping to combat inflation.

2. Evaluate Liquid Mutual Funds Carefully:

   • Fund House Reputation: Choose funds from reputable Asset Management Companies (AMCs) with a strong track record.
   • Expense Ratio: Opt for funds with lower expense ratios, as these directly impact your net returns.
   • Portfolio Quality: Look at the fund's portfolio to understand the credit quality of the instruments it invests in. Funds investing in higher-rated (e.g., AAA-rated) instruments are generally safer.
   • Past Performance: While not indicative of future results, consistent performance over time can be a good indicator.

3. Understand Taxation: Be fully aware that any gains from your liquid mutual fund investments (if purchased after April 1, 2023) will be taxed at your income tax slab rate. Factor this into your expected net returns. For example, if you are in the 30% tax bracket, a 6% gross return would translate to a 4.2% net return (6% - 30% of 6% = 4.2%). Even with taxation, this might still be better than a 3.5% savings account.

4. Consider Ultra-Short Duration Funds (with caution): For a slightly higher return potential than liquid funds, and if you are comfortable with a very marginal increase in risk and slightly longer average maturity, you could consider ultra-short duration debt funds. However, for a core emergency fund, liquid funds are generally preferred due to their superior liquidity and lower risk profile.

5. Regular Review: Periodically review your emergency fund. Re-evaluate the amount needed based on your changing expenses and income. Also, monitor the performance of your liquid funds and prevailing interest rates.

By carefully segmenting your emergency fund and choosing appropriate instruments, you can strike a better balance between the critical needs of safety and liquidity while also addressing the erosion of purchasing power due to inflation. This strategic approach will ensure your financial safety net remains robust and effective.

TAGS: Emergency Fund, Liquid Mutual Fund, Financial Planning, India, Inflation

Tags: Emergency Fund Liquid Mutual Fund Financial Planning India Inflation

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