If a savings account could give assured super-high returns, then there wouldn’t be any reason to invest elsewhere.
But apart from few banks that offer differential interest rates on balance parked in savings accounts, the interest rates are pretty low, around 4%. So it actually doesn’t make any sense to keep very large amounts in savings account for long.
Let’s try to understand how one can go about deciding how much money to park in various instruments like savings account, fixed deposits and liquid funds.
Suppose you earn Rs 85,000 a month and the expenses are Rs 60,000.
It is said that one should always have some money saved for emergencies.
In financial planning terms, this is called the emergency or contingency fund. How big should this fund be? A minimum of three months’ worth of expenses and ideally about six months.
So in the above example, this translates into 3 to 6 times of Rs 60,000, i.e. Rs 1.8 lakh to Rs 3.6 lakh. Let’s stick with Rs 3.6 lakh.
One can argue that since emergencies are all about quick access to money and having liquidity, one should keep all the Rs 3.6 lakh in savings account.
You definitely can and a lot of people actually do it. In fact, different people are comfortable with different levels of money parked in their savings accounts.
But from an investment perspective, leaving all of it there would be the least efficient way of managing it.
It can be safe to say that there is a very remote possibility that all the money Rs 3.6 lakh would be required in one-shot on immediate basis.
So what more can be done to better deploy the funds, without sacrificing liquidity or taking risk?
At very first, keeping money worth 1 to 2 months expenses in savings account should be considered.
This way, you will be able to withdraw the first Rs 60,000 to Rs 1.2 lakh immediately if required. This is enough ‘immediate liquidity’ for most people. Also, the interest income from savings bank account is tax-free up to Rs 10,000 every financial year.
So if let’s say the bank gives 4%, then you can park up to Rs 2.5 lakh in a savings account without worrying about tax. It is another matter that 4%, even after tax, is not high enough to park a lot of money.
What should now be done with the remaining amount from Rs 3.6 lakh (after parking Rs 60,000 to Rs 120,000 in savings account)?
There are two options – Bank Fixed Deposits or Liquid Funds.
Fixed deposits from banks need no introduction. They have been a favourite for savers since generations.
But the choice between the two or how much to deploy in each depends on who is comfortable with what, how much risk one is ready to take, the period of investment and some idea about how much money would be withdrawn in case of need.
Both instruments serve similar functions but differ on certain aspects. Let’s try to discuss them briefly here:
• Debt funds have some risk (interest rate risk, credit risk, etc.) and hence, are capable of providing better returns than fixed deposits (FDs). But this is not guaranteed. FD interest rate is known beforehand. Same is not the case with liquid funds. But well-run liquid funds are generally able to beat the interest rate earned on FDs of similar duration, that too if held for 3+ years (where they get better tax benefits).
• FD interest income is added to normal income and taxed as per one’s tax slab. But liquid funds held for 3+ years, the gains are classified as long-term capital gains and taxed at 20% with indexation. So this lowers the impact of taxes on liquid fund returns. That’s not all. Tax on FD interest is to be paid prospectively even before interest is received. But taxes on gains from liquid fund are to be paid only at the time of selling.
• When it comes to liquidity, FDs are generally available in 1-2 days’ time. And if made online, it’s possible to get money in less than a day (and in some cases immediately too). But premature withdrawal attracts penalty and reduces the applicable interest rate. Liquid funds, on other hand, are also available with 1-2 working days. But there is no penalty for premature withdrawal and you can withdraw any amount you wish. It’s not like FD where partial withdrawals are generally not possible. One needs to break the complete FD prematurely even if the need is for a smaller amount.
Based on these factors, one can decide whether to just put the remaining money in FD or in liquid funds or divide it amongst the two.
Here is a sample suggestion of how to park an amount equal to six month’s expenses for common people:
• Park money worth 1-2 months of expenses in savings account. This takes care of immediate liquidity needs.
• If it’s all about safety for you, then simply stick with FD for the remaining amount.
• But if you are willing to see the benefits of liquid funds (like potential for better returns, better taxability if held for long, decent liquidity, ability to withdraw partial amounts as and when needed, etc.), then consider putting some money in liquid funds too. You can split it equally between FD and Liquid fund for starters and gradually increase.
• If it’s a falling interest rate scenario, one can be tactical and even go big on FDs to lock-in higher interest rates. Taking the FD route in a falling rate scenario will allow him/her to lock-in comparatively higher rates for the chosen duration. In a way, it eliminates the reinvestment risk for a decent duration if a longish FD tenure is chosen. In a falling rate scenario, my understanding is that debt funds would maintain comparatively higher portfolio maturities. Some debt fund managers might deliver even better returns, by being tactically opportunistic by maintaining higher portfolio maturities.
• But for a conservative investor, he might still prefer the surety of an FD when there is an opportunity to lock-in rates at higher levels, given the fact that debt funds space is not just open to unfriendly-rate-movement-risk but also to other rare-but-not-impossible scenarios of downgrades, partial defaults of papers held, etc.
However, if you are not sure what’s right for you, then consult your investment advisor to guide you with this and other aspects of financial planning.