Before starting a fresh debate on ‘liquid funds VS FDs’, let me differentiate the two.
A Fixed deposit (FD) is a secured investment scheme offered by financial institutions and serve as one of the easiest investment avenues for individuals. Fixed deposit interest rates are mostly higher than that of any savings account.
Such financial tools also come with a fixed investment horizon, making them less liquid. It is also considered to be among those financial instruments that have a low-risk component because of its fixed rate of returns.
Liquid mutual funds are one of those mutual funds in India which invest in debt instruments. Such funds mostly are short-term in nature and can be withdrawn without much hassle. The high liquidity and the scope to earn substantial returns on investments make liquid funds a more beneficial investment option.
Liquid Funds Vs Fixed Deposits
Over the past few decades, a slow but steady shift has been noticed in the investment market pertaining to liquid mutual funds. Conservative investors who were initially more comfortable with the idea of channeling their funds into fixed deposits are now exploring liquid debt instruments.
The shift may be accredited to several factors, which may be or may not be directly related to the performance of the fixed deposits and liquid funds.
For example, in 2016, demonetization became an important factor that reduced the rate of returns on deposits. While liquid mutual funds saw a hike in the same period owing to their several features and associated benefits.
Here are a few of such features that make liquid funds better than the traditional fixed deposits –
1. Liquidity and lock-in period
In a few words, liquidity can be defined as the level of ease with which funds can be withdrawn from a particular investment.
When it comes to liquid funds, debt-category funds tend to have higher liquidity than that of traditional fixed deposits. Investors can avail a quick disbursal of funds into their personal account easily and within a few working days.
A typical fixed deposit comes with a lock-in period that ranges from 1-5 years. If the depositor wishes to withdraw their deposit before the lock-in period, they would have to pay the penalty or additional fee to avail it.
2. Returns on Investment (ROI)
When it comes to the returns on investments, the rate of interest on fixed deposits is pre-determined by financial institutions based on the time horizon of the deposit. While for debt funds, the same depends on the overall rate of interest that is prevalent in the investment market.
Though the current the rate of returns applicable on both fixed deposits and liquid funds around 7%, they tend to vary at times.
For example, when the economy is stagnant, and the rate of returns is significantly lower, a liquid mutual fund investor may earn better returns than a fixed deposit holder. Such a difference may manifest in forms of regular earnings and overall capital appreciation.
Additionally, when the economy is thriving, and the rate of interest is all set to rise, the debt securities are more likely to offer a higher rate of returns.
Now, you must be aware of the fact that liquid funds mostly invest in instruments that come with a short investment period of up to 91 days.
This offers investors the opportunity to purchase new commercial papers and securities with a higher rate of returns in place of the expired ones that were issued at a lower interest rate.
In such a situation, the liquid fund investors are more likely to earn better returns on their investments in a year than the fixed deposit holders.
3.Taxation And Associated Benefits
Liquid fund investors are considered to be in a better position than fixed deposit holders in case of taxation on their respective investments.
When it comes to tax on liquid funds, the investors are entitled to avail tax indexation, which directly helps them to lower their burden of tax-related expenses.
The long-term capital gains made on those liquid funds that were held for over 3 years are applicable for taxation at the rate of 20% post indexation. While the short-term gains made on such funds are taxed in accordance with the individual’s tax slab.
Now, in the case of fixed deposit holders, the returns earned through their deposit is added to the aggregate income of the investor. After the addition, the total is subjected to a rate of taxation that is pre-determined by their tax slab.
Moreover, if the returns earned on a fixed deposit exceed Rs. 10,000 in an annum, the bank would further deduct a TDS on it at the rate of 10%.
So, if an investor belongs to the 30% tax bracket, the returns earned through a fixed deposit would incur a 30% charge and an additional surcharge on it.
The tax benefits on liquid funds make it an attractive alternative to fixed deposits. It is also a significant advantage of mutual funds over fixed deposits.
4. Risk factor
Inflation tends to erode an individual’s savings faster than most other financial crisis. Though the risk associated with both debt mutual funds and fixed deposits are mostly similar, there are a few differences here and there.
Investing in fixed deposits is considered to be almost risk proof, which is why most investors with a conservative investment portfolio feel drawn towards them.
On the other hand, investing in liquid funds is considered to be slightly riskier because they are subjected to fluctuating prices, rate of interest and etc. that influence their NAV.
But the NAV of liquid funds does not fluctuate that frequently, owing to their short investment horizon. They are better equipped at pacing up and performing against inflation.
The answer to the question, “Are liquid mutual funds better than FDs?” can be obtained easily, if you decide to take into account the numerous benefits that come along with it.
Benefits like tax advantages, higher liquidity, and shorter time horizon definitely make liquid funds very attractive options.
To Sum Up
While liquid funds come with a slew of benefits, they are not completely immune to risk. As an investor, always weigh in factors related to the investment market, your risk appetite, time horizon, and future financial goals before investing.