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FD Vs Liquid Funds: Key Differences

Updated on: 09 Jan 2024 | 8 min read

Fixed deposits (FDs) are considered one of the most risk-free investment options, and they have been a favourite among investors for decades. While the returns are fixed and assured, they also 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 consider parking 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 also 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 make the right decision when investing in these two instruments.

FDs & Liquid Funds: What are They?

Fixed deposits are a type of fixed-income bank deposit where you put away a lump sum for a fixed period of time, 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.

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 do carry an element of risk, as the returns are not fixed or assured.

How Does Fixed Deposits Work?

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 rate of interest, 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.

How Does Liquid Funds Work?

As the name suggests, liquid funds 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 also 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 tax-efficient. This is the case with any debt fund.

Difference between Liquid Funds and FDs

Here’s a snapshot of the key differences across various parameters:
 

ParameterLiquid FundsFDs
Rate of returnsIt 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 withdrawalA low penalty only if redeemed within seven days The penalty is on the higher side 
Minimum investment ValueUsually ₹1000, though some asset management companies have a cap of ₹5,000One can start investing with ₹100 
Investor profileInvestors 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 horizonLiquid 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 rateThe 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

Who Should Invest in FDs?

Fixed Deposits are Ideal for those with minimal risk tolerance as they offer a secure investment option. When considering an NBFC, check ratings from agencies like CRISIL. Bank FDs are generally safer. FDs are a favourable long-term investment for those seeking higher returns than savings accounts with low-risk tolerance.

Who Should Invest in Liquid Funds?

Liquid funds invest in secure fixed-income instruments, aiming for capital protection and liquidity. They prioritise high-quality instruments, making them safer than many mutual funds but riskier than fixed deposits. Consider them with a low-medium risk tolerance. Although not guaranteed, liquid funds typically yield better returns than FDs.

Why you should invest in FDs and Liquid Funds

Diversifying your investment portfolio by balancing the risks with rewards is important. 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.

Final Thoughts

When weighing the pros and cons of liquid funds vs FDs, it is important to consider your needs and how each instrument can serve them. It is also important to understand the risks involved and whether your risk appetite matches your instrument of choice. You can make an informed decision by having all the information at hand and understanding the terms and conditions of the specific liquid fund or fixed deposit you wish to invest in. Both instruments offer a degree of flexibility, so choose appropriately.

FAQs

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 if you wish to park surplus funds for a brief period without a fixed 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 offer higher returns, but with a higher risk.

How do the following instruments compare – liquid funds vs debt funds vs FDs?

Debt fund is a larger umbrella term for all mutual funds that primarily invest 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. Though debt funds and liquid funds are less risky than equity-based instruments, 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, and not equity. Hence, the returns are comparatively lower. However, the fund managers actively manage the fund to capitalise on market opportunities. Hence, 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 per day. However, if you withdraw funds within seven days of opening, you may have to pay a small penalty.

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