In India, fixed deposits or commonly referred to as FD has been a popular savings instrument for investors for decades.

FDs have a fixed investment period and therefore are less liquid in nature.

Also, they offer a fixed rate of return and therefore entail a very low risk comparatively.

Liquid funds, on the other hand, are those mutual funds in which investments are made in financial instruments which can be easily withdrawn to get immediate cash or liquidity.

FD vs liquid funds

1. Liquidity

Liquidity refers to how easily money can be taken out from an investment.

It goes without saying that an investment in any liquid fund is much more liquid, much more flexible in terms of the investment duration as compared to a traditional FD.

An investment is FD is locked in for the duration of the investment period, generally 1-5 years.

These funds are less liquid as any redemption before the investment period, commonly referred to as pre-mature withdrawals, attracts some sort of extra charges in the form of penalty or fees.

On the other hand, proceeds from liquid funds redemption are generally credited to the investor’s bank account in 1-2 working days.

2. Returns

Liquid returns generally deliver similar returns when compared to FD.

The average returns delivered by liquid funds fall in the range of 6.6% to 6.7% p.a. and FDs are also giving returns around the same mark.

3. Prospective Returns

In the present scenario of rising interest rates in the economy, the expected returns for all short-term funds in general and liquid funds, in particular, is set to increase from the present levels.

According to the research of some analysts, the returns from liquid funds over the period of time could exceed the returns offered at present by FD.

The explanation for the above goes as follows:

Liquid funds generally invest in market instruments which have a very short maturity of up to 91 days.

In the event of rising interest rates, the debt securities in which the liquid funds invest shall also offer higher interest rates.

Once the instruments such as commercial papers issued at lower rates expire, unlike FD, liquid funds are in a position to buy new papers or other securities bearing higher interest rates.

In this event, the one-year returns for liquid funds can be equal to or even higher than the one-year returns offered by FD.

However, this is a prospective scenario which would only materialize in case the interest rates continue their northward movement.

4. Tax

Liquid funds score higher points here.

The reason for the above is that interest income from a bank FD is added to the total income of the investor or assessee and then taxed according to the tax slab which is applicable to the assessee.

Moreover, if the interest income arising out of an FD is more than ₹10,000 in a year, then the bank deducts a TDS or tax deducted at source at the rate of 10%.

Therefore, assuming that the investors fall in the 30% tax bracket, any interest from a bank FD is charged at 30% plus surcharge.

Liquid funds, on the other hand, entail a lower tax expense owing to the benefit of indexation.

Long-term capital gains on liquid fund schemes which are held for a period of more than 3 years are taxed at 20% after allowing for the benefit of indexation.

Indexation of costs allows for a lower income for the purpose of earnings calculation owing to the increased cost allowance.

Therefore, in the case of an investment in liquid funds, the effective tax rate is reduced due to the benefit of indexation. This makes a huge difference in the net tax outgo for the investor.

5. Risk

The risk associated with them is nearly similar.

Liquid funds are riskier, albeit only by a small notch than traditional bank FDs on account of the credit risks.

FDs are perceived to be almost risk-free and therefore preferred as a go-to investment option for risk-averse investors.

Liquid funds are subject to risks from fluctuating prices, interest rates, and other macro factors and thus fluctuating NAV.

Practically speaking though, the fluctuation in the NAV of liquid funds is very little and doesn’t not affect the investor in any significant manner.

Conclusion

After analyzing the above parameters, we can understand that liquid funds have their advantages over FD in some very important criterion.

They have a higher liquidity as compared to FD, with no extra charge for pre-mature withdrawal. Moreover, liquid funds have no fixed lock-in period, unlike bank FD.

Liquid funds also score better than FD as regards to the tax outgo for investors is concerned.

Investors of liquid funds enjoy the benefit of indexation, which reduced their total interest earned for the purpose of tax calculations.

All in all, liquid funds are a very good option over FD for investors looking to invest their money for earning decent returns and maintain high liquidity.

Happy Investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.