Liquid Funds vs FD: A Comparative Analysis
In India, fixed deposits are the oldest and most trusted form of investing.
Before shares and mutual funds started gaining attention, fixed deposits were the go-to name for investment and steady returns. They offered many benefits, such as low risks, reasonable returns, and high liquidity.
Over the years, different types of funds have been launched to suit the requirements of different kinds of investors, particularly those who prefer FDs. Liquid funds have a similar risk profile to FDs, and hence, most investors compare them with fixed deposits.
Here is what you should know before you make an investment in either of the instruments.
Liquid Funds Vs FD: Understanding the Meanings
Fixed Deposits (FDs): FDs are perhaps some of the most conservative investment avenues that the general public has available with banks and non-banking financial companies (NBFCs) operating in India. These are ideal for risk-averse investors who want a sure-shot return: FDs provide fixed interest over a predetermined tenure.
FDs are insured up to a sum of ₹5 lakh per bank under the DICGC scheme, thereby making it an extremely safe and secure investment avenue for parking savings. However, they have low liquidity, and early withdrawal often incurs an added penalty. The interest income is added to an investor's taxable income and taxed at the slab rate applicable to him.
Liquid Funds: Liquid funds are debt mutual funds that place their investments in short-term, low-volatility fixed-income instruments, which may include treasury bills, commercial papers, and certificates of deposit. They offer a little better return than FDs, but the low-to-moderate risk comes with these, as they are market-linked.
Liquidity is high, and hence, liquid funds are perfect for short-term investments, as the maximum maturity term they allow is 91 days. The tax efficiency will depend on the holding period. Long-term holds of three years or more will be taxed at 20% post-indexation, while any gains earned in the short term will be brought to your income slab for collection as tax.
Comparison Between Fixed Deposits and Liquid Funds
Liquid funds Vs FDs, let’s compare two of them for a better understanding:
FD vs Liquid Funds - A Comparative Analysis |
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Feature |
Fixed Deposits |
Liquid Mutual Funds |
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Risk |
These are considered extremely low-risk investments since they are offered by banks or NBFCs and usually have an insurance policy protecting the invested capital and interest up to Rs.5 lakh per bank account. |
Liquid mutual funds invest in fixed-income instruments. These instruments are affected by the market volatility and overall state of the economy. Hence, these funds carry a relatively higher risk as compared to fixed deposits. |
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Returns |
Fixed deposits offer a fixed rate of return that is governed by the Reserve Bank of India based on the condition of the economy and the financial system in the country. While the returns are higher than savings accounts, they are lower than liquid funds. |
Liquid mutual funds do not offer any guaranteed returns. However, they tend to offer better returns than fixed deposits. It is important to ensure that the fund manager does not take high risks while managing the fund’s portfolio. You need to read the offer document carefully before investing. |
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Liquidity |
Fixed deposits have a maturity date and the interest rate is offered based on the principal amount and tenure of the deposit. While you can prematurely withdraw your funds, a penalty (usually around one percent of the applicable interest) is levied for the same. Hence, while fixed deposits offer liquidity, it comes at a price. |
While you could redeem liquid fund units at any time without any exit loads, last year, the SEBI announced exit loads for liquid funds redeemed within seven days of holding them. This is a graded structure. For instance, holding a liquid fund for one day and exiting it will attract an exit load of 0.007%, and holding for two days – 0.0065%. From the seventh day onwards, there is no exit load on redemptions. Hence, liquid funds offer better liquidity at lower penalty charges than FDs. |
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Investment Horizon |
You can invest in a fixed deposit for a tenure ranging from seven days to ten years. |
Liquid funds have a maturity of up to 91 days. |
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Taxation |
The interest earned from fixed deposits is added to your annual income and taxed as per the applicable tax slab. Also, whenever interest is paid out or accrued, the bank/NBFC deducts 10% TDS. At the end of the year, you need to deduct the TDS amount from your overall tax liability and pay the difference. You can also invest in a tax-saving fixed deposit with a lock-in of three years to claim tax deductions of up to Rs.1.5 lakh under Section 80C of the Income Tax Act, 1961. |
If you hold liquid fund investments for more than three years, your returns will be considered long-term capital gains and taxed at 20% after indexation. On the other hand, for investments held for three years or less, the returns are taxed per your applicable income tax slab. |
How do you choose between Liquid Funds and FD?
As you can see, both fixed deposits and liquid funds have certain pros and cons. So, how do you choose between the two?
Who should consider investing in a fixed deposit?
- Fixed deposits (FDs) are best suited for investors with very low or zero risk tolerance.
- Bank FDs are generally safer than those offered by Non-Banking Financial Companies (NBFCs), so it is crucial to verify an NBFC’s credit rating (e.g., CRISIL rating) before investing.
- FDs offer a more secure, long-term investment option than savings accounts, providing stable returns with minimal risk.
- Ideal for conservative investors, FDs combine higher returns than standard savings accounts with low risk, making them attractive for risk-averse individuals seeking steady growth.
Who Should Invest in Liquid Funds?
- It caters to the requirements of investors who want to invest for shorter periods and keep their funds for very short durations, say up to 3 months, for higher returns than the savings account offers.
- Those who are in need of emergency liquidation of funds and come with no or low exit loads after 7 days.
- Those people are comfortable with low to medium-level risk who prefer stable returns with slight fluctuations.
- Those investors who are seeking to optimize tax, if the holding period is more than three years, where they can avail of long-term capital gains as well as indexation.
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Conclusion
Liquid funds invest in fixed-income instruments and endeavor to offer capital protection and liquidity to investors. Hence, they invest only in high-quality instruments. This makes them safer than other mutual funds. However, they are riskier than fixed deposits.
Hence, you can consider investing in liquid funds if you have a low-medium tolerance for risk. While these funds don’t assure returns, they offer better returns than FDs.
Happy Investing!