Comparison Between Liquid Funds And Fixed Deposits

Both liquid funds and fixed deposits are low-risk investment options that are popular among Indians. But there are certain differences between these investments that you must know to make informed investment decisions.

Let’s understand what liquid funds and fixed deposits are and compare them on different factors.

What Are Liquid Funds?

Liquid funds are a type of mutual fund that invest predominantly in short-term debt instruments. Liquid funds invest in money market instruments such as treasury bills, certificates of deposit, commercial papers, and other highly liquid, low-risk securities with short maturity periods. As the name suggests, Liquid Funds are popular because of their ability to provide liquidity, allowing investors to withdraw their money easily and smoothly. This makes them ideal for investors with short-term financial goals.

What Are Fixed Deposits (FD)?

A Fixed Deposit (FD) is a relatively low-risk investment where investors deposit a lump sum in a bank for a fixed period. Investors can withdraw their investments at maturity. Some banks may allow premature withdrawal but charge a nominal penalty fee.

An FD offers a predetermined interest rate for the agreed tenure. A Fixed Deposit earns a guaranteed interest rate till maturity; after which the investor can withdraw their corpus.

Comparing Liquid Funds With Fixed Deposits

Let’s compare liquid funds with fixed deposits on multiple aspects.

Returns and Investment Flexibility

Fixed Deposits typically offer fixed interest rates for a predetermined tenure. In contrast, Liquid Funds offer market-linked returns from short-term securities, which may be higher or lower than FD returns depending on market conditions and the fund's performance.

Liquid Funds generally allow investors to request redemptions on business days, although the time taken to receive the money depends on the scheme and applicable rules. Many FDs also allow premature withdrawals, but penalties or restrictions may apply.

Liquidity

While premature FD withdrawals may attract penalties, Liquid Funds offer easy access to money through redemptions on business days. However, processing times and any applicable exit loads depend on the scheme, and instant redemption is available only under eligible schemes and within prescribed limits.

Their liquidity features make Liquid Funds a possible option for short-term financial goals. Investors should consider market risk and redemption timelines before using them for emergency funds.

Taxation

Taxation is a critical consideration for investors. Fixed Deposit interest is added to the investor's income and taxed according to their applicable income tax slab. Gains from Liquid Funds covered by Section 50AA are generally treated as short-term capital gains, regardless of the holding period, and taxed at the investor's applicable income tax slab rate. Indexation benefits are not available for these gains.

Interest rate risk

Fixed Deposits can involve opportunity risk when interest rates change. If rates rise, an existing FD may continue to earn its agreed rate, which could be lower than the rates offered on new FDs.

Liquid Funds invest in short-term securities, allowing their portfolios to adjust as existing securities mature and new ones are purchased. Their returns may respond to changes in market interest rates, but they are not guaranteed and can still be affected by interest rate and credit risks.

Systematic Withdrawals

Fixed Deposits can generally be renewed at maturity, while some offer periodic interest payouts. Liquid Funds allow investors to set up a systematic withdrawal plan (SWP) to redeem a fixed amount at regular intervals, subject to available units and applicable scheme terms. An SWP allows investors to redeem a predetermined amount at regular intervals through an SWP.

Expense Ratios

Mutual funds, including Liquid Funds, have an expense ratio that covers fund management and operational costs. Liquid Funds may have relatively low expense ratios compared with some other mutual fund categories. However, expenses vary across fund schemes, so investors should compare the expense ratios of available funds before investing.

Diversification

Liquid Funds invest in a diverse range of money market instruments, spreading the risk across multiple securities. By investing in securities from different issuers, Liquid Funds can reduce their dependence on any single issuer. Do know that diversification does not eliminate credit risk.

Inflation-adjusted Returns

Given the dynamic nature of interest rates and inflation, the real returns from Fixed Deposits might not always outpace inflation. Liquid Funds may generate returns that exceed inflation in some periods, but this is not guaranteed. Since liquid funds are designed for short-term investments, investors should compare their expected after-tax returns with inflation and consider other investment options for long-term goals.

FAQs

What are Liquid Funds?

Liquid Funds are mutual funds that invest in short-term securities that offer market-linked returns and easy redemption options.

Are Liquid Funds better than Fixed Deposits?

Liquid Funds may offer higher returns, but they carry market risks, while FDs offer a fixed interest rate, making returns more predictable.

How are Liquid Funds taxed compared to FDs?

Liquid Fund gains are taxed at the applicable income tax slab rate under current rules, while FD interest is also taxed at the applicable slab rate.

Can I withdraw money from Liquid Funds anytime?

Yes, you can submit a redemption request anytime on business days, but it may take some time to receive the money in your linked bank account.