Comparing Liquid Funds vs FD: Which Offer Better & Much Higher Returns?
Fixed deposits (FDs) are considered one of the most risk-free investment options and have been a favourite among investors for decades. While the returns are fixed and assured, they tend to be much lower than other instruments, such as stocks or mutual funds. Investors looking for low-risk investments with high liquidity and slightly higher returns can also park their funds in liquid funds.
Both liquid funds and FDs invest in a spectrum of debt instruments like money market instruments such as treasury bills, government bonds, and certificates of deposits. However, liquid funds carry some extra risk but offer slightly higher returns, although not as high as equity mutual funds.
In this blog, we shall understand the similarities and differences between liquid funds vs FDs and how to decide when investing in these two instruments.
What is a Fixed Deposit?
Fixed deposits are fixed-income bank deposits where you put away a lump sum for a fixed period, ranging from seven days to 20 years. Fixed deposits typically yield higher interest than a savings bank account. They earn a fixed rate of return over the tenure. When the interest is paid out at regular intervals – quarterly, monthly, bi-annual or annual – it is known as a non-cumulative fixed deposit. In contrast, a cumulative fixed deposit is one where the interest is paid at the end of the tenure, along with the principal.
Banks, deposit-taking non-banking financial companies (NBFCs), and the post office offer fixed deposits. The main advantage of fixed deposits is that they offer assured returns at a predetermined interest rate, time frame, and intervals. In addition, they present lower to negligible risk and are a flexible investment option where you can open a deposit with a minimum amount of ₹100.
Fixed deposits usually offer interest rates between 2.5% to 8.5%. You can make a premature withdrawal by paying the penalty.
While fixed deposit returns are typically taxable, some banks offer five-year tax-saver FDs under Section 80C of the Income Tax Act.
Also Read: Experience financial growth with unmatched Bajaj Finance FD Rates
What are Liquid Funds?
A liquid fund is a type of debt mutual fund that primarily invests in securities with a maturity period of only 91 days. These securities include treasury bills issued by governments (also known as T-bills), short-term government bonds, commercial paper (CPs), bank term deposits, and certificates of deposits (CDs), among others. Liquid funds are relatively low-risk as compared to equity-based and hybrid mutual funds. However, they carry an element of risk, as the returns are not fixed or assured.
On the other hand, liquid funds, as the name suggests, are ideal for individuals looking to park surplus funds for a brief period, as they offer high liquidity and capital protection. For instance, if you have some funds that you want to invest in buying a home, launching a business, or buying a car, after a few months, you can put them away for safekeeping into a liquid fund. Liquid funds offer higher returns than savings accounts and sometimes more than fixed deposits with minimal risk.
Liquid funds are not tax-free and do not offer any tax deduction benefits. Profits earned on a liquid fund redemption before three years will be added to your income and taxed as per your income tax slab. If you hold liquid funds for over three years, the profits are taxed as capital gains at the rate of 20%, making them.
Why you should invest in FDs and Liquid Funds
Diversifying your investment portfolio by balancing the risks with rewards is essential. Putting all your capital into equity-based instruments such as stocks and equity mutual funds can drive high returns. But it also leaves your portfolio vulnerable to the risk of capital loss when the market is volatile. On the other hand, if you invest around 20 to 25% of your portfolio in debt instruments, you are assured of a diversified portfolio.
Difference between Liquid Funds and FDs
Here’s a snapshot of the key differences across various parameters:
|Rate of returns||It tends to be higher than fixed deposits. However, the returns are not assured or guaranteed||The rate of return is fixed and tends to be lower than liquid funds|
|Premature withdrawal||A low penalty only if redeemed within seven days||The penalty is on the higher side|
|Minimum investment Value||Usually ₹1000, though some asset management companies have a cap of ₹5,000||One can start investing with ₹100|
|Investor profile||Investors with low to medium risk appetite/ Relevant for both short-term and long-term investors||Investors with a low-risk appetite/ Relevant for both short-term and long-term investors|
|Investment horizon||Liquid funds invest in securities with a maturity of up to 91 days||The tenure of a fixed deposit is between 7 days to 20 years|
|Tax implications||When liquid funds are redeemed after three years, the returns are taxed as long-term capital gains at 20%. Tax Deducted at Source is not applicable. When liquid funds are redeemed before three years, the returns are taxed as per the income slab rate.||The interest is added to annual income and taxed as per income slab 10% Tax Deducted at Source is applicable. Five-year tax-saver FDs offer a tax deduction of up to ₹1.5 lakh under the Income Tax Act of 1961.|
How to choose between fixed deposits and liquid funds?
As mentioned above, both FDs and liquid funds have a risk-to-return ratio; it depends on your risk ability to choose between the two. Here are a few points to consider before choosing between the two.
Who should invest in FDs?
For investors who want to invest in instruments with no risk and want to earn an average return, Fixed Deposits are ideal for them. DICGC provides insurance coverage of up to ₹ 5 lakhs per investor. However, if you are opening an FD account with an NBFC, checking the corporation’s credit rating before investing is suggested.
FDs are an excellent long-term investment option with higher returns than the savings account.
Who should invest in Liquid Funds?
Liquid funds are less riskier than equities but more from FDs. Investors who want to invest for a shorter term with a moderate risk appetite can invest in liquid funds. The goal is to provide capital protection and liquidity to investors.
The returns on Liquid funds are not assured but are better than FDs. Liquid funds are best for you with a low to moderate risk appetite.
Liquid Funds are an investment that puts your money into short-term loans and can be withdrawn whenever needed. The maturity period of liquid funds is 91 days.
Fixed Deposits allow you to invest your money and earn good interest on it safely. Fixed deposits offer an investment period ranging from 7 days to 20 years.
Fixed Deposits and Liquid Funds are safe ways to grow your money with little risk.
Liquid debt funds vs FDs – which is a better investment?
Both instruments have their pros and cons. A liquid fund can earn higher returns than a fixed deposit. It is ideal to park surplus funds briefly without a specified investment horizon. There is no lock-in period, and you can retrieve the amount within 24 hours without a penalty as long as the amount is redeemed after seven days. However, a liquid fund investment is slightly riskier than a fixed deposit.
Is a Liquid Fund better than a savings account?
Both liquid funds and savings bank accounts offer high liquidity. However, liquid funds provide higher returns but with a higher risk.
How do the following instruments compare – liquid funds vs debt funds vs FDs?
Debt fund is a more extensive umbrella term for all mutual funds primarily investing in debt securities. With this category, liquid funds only invest in debt securities with a maturity period of 91 days. Other debt funds may also invest a small portion in equity, gold, and other instruments. On the other hand, fixed deposits are fixed-income investments that are not market-linked. Debt and liquid funds are less risky than equity-based instruments, but they still have some risk factors, unlike fixed deposits.
Why are liquid fund returns lower than equity funds but higher than fixed deposits?
Liquid funds invest in debt securities, such as money market instruments, with a maturity period of 91 days, not equity. Hence, the returns are comparatively lower. However, the fund managers actively manage the fund to capitalise on market opportunities. Therefore, they offer higher returns than fixed deposits.
Can I withdraw money from a liquid fund?
Liquid funds offer an instant withdrawal facility that enables investors to redeem units instantly. According to SEBI guidelines, you can redeem up to INR 50,000 daily. However, if you withdraw funds within seven days of opening, you may have to pay a minor penalty.
Are liquid funds risky?
Liquid funds are considered low-risk debt instruments primarily due to their substantial investments in government securities. They predominantly allocate their funds to instruments with maturities of fewer than 91 days, which results in their exposure to minimal risk.
Where should I invest in the short term?
If you are looking for short-term investments, you can invest in corporate bonds, T-bills, Commercial paper, Recurring Deposits, etc.
Are liquid funds tax-free?
When liquid funds are redeemed after three years, the returns are taxed as long-term capital gains at 20%. Tax Deducted at Source (TDS) is not applicable. When liquid funds are redeemed before three years, the returns are taxed as per the income slab rate.
What are the advantages and disadvantages of investing in liquid funds vs. fixed deposits?
Liquid funds provide greater flexibility and the potential for higher returns, but they also come with exposure to market risk. In contrast, fixed deposits offer more stability but typically yield lower returns and offer less flexibility.
What are the things you need to consider before choosing liquid funds?
Look out for funds that uphold a well-diversified portfolio comprising high-quality debt instruments. Consider the average maturity and duration of the portfolio, as these factors can influence the fund’s sensitivity to changes in interest rates.
Why are liquid funds better than an FD?
Liquid funds are mutual funds that allocate their investments towards short-term debt instruments, prioritising low-risk and easy liquidity. Compared to fixed deposits, they generally feature reduced charges while potentially delivering higher returns, thanks to professional management and lower operating expenses.