Liquid funds vs Fixed Deposits – Which is the Better Investment?

Fixed deposits (FDs) are one of India’s favourite investment options considering the no-risk feature and guaranteed returns. Fixed deposits are often used by individual investors for short-term investments. Since the past few years have seen a significant drop in fixed deposit interest rates, investors are starting to look for other investment avenues for parking their funds and maximizing wealth.

One investment alternative that is fast gaining popularity among Indian investors is mutual funds, since these tend to offer better returns as compared to fixed deposits. Within mutual funds, liquid fund options enjoy higher preference. Mutual funds are managed by professional fund managers who ensure appropriate portfolio diversification and regularly monitor the risk levels. Here we will discuss Liquid funds Vs Fixed Deposits to help you make a better decision while investing.

What are liquid funds?

Before learning about liquid funds, let’s first try to understand how mutual funds work in general. These investment tools pool funds from investors to further invest it in different asset classes. The mutual funds then distribute returns to investors either in the form of dividend income or through capital gains.

Liquid funds are a type of mutual funds that fall under the short-term investment category. Here, an investor’s money is allocated to debt-based securities and other fixed-income instruments, such as treasury bills, commercial papers, etc. The maximum period of investment is 91 days. In liquid funds, an investor can redeem funds at any time and the same gets credited to their bank accounts within 1-2 business days.

What is a fixed deposit?

Fixed deposits act as a saving mechanism that requires investors to park their extra funds for a few days, months or even years with a bank. Once invested, investors cannot withdraw their funds for the period of investment, which is called the lock-in period. Banks periodically pay investors the interest earnings on the deposit amount and allow investors to withdraw their funds after the lock-in period.

Liquid funds Vs Fixed Deposits (FD)

Let’s understand these two concepts in further detail by looking at some of the comparative factors.

Risk

Fixed deposits have existed as an investment vehicle for many decades and enjoy investor preference since these are mostly risk-proof. When it comes to liquid funds, these have moderate risk levels, although they may be lower compared to other mutual funds. Liquid funds often come with market risks, interest rate risks, etc. The NAV of a liquid fund is usually impacted by these factors. Thus, when compared to fixed deposits, liquid funds can be  slightly risky. 

Returns

FD interest rates generally range between 5% to 6% for general citizens and around 7% for senior citizens as of Sep 2021. The interest rates are linked to policy rates determined by RBI. An FD investment grows at a fixed interest rate throughout the investment tenure. Therefore, these may not be an ideal choice for investors who are looking to maximize their returns.

Liquid funds earn profits through interest rates ranging from 7% to 9% (depends on market conditions). This is still higher than FD earnings. While liquid funds can fetch higher returns than FDs, it depends on the portfolio strategy adopted by the fund manager.

Liquidity

FD investment does not allow premature withdrawals and there are penalty charges for early withdrawal. Therefore, in case of an emergency, an investor cannot use these funds to meet their requirement. In some cases, banks may also impose a liquidation fee. Liquid funds, on the other hand, offer higher liquidity and can benefit investors in case of an emergency. Investors of liquid funds can withdraw funds at any time during the investment horizon.

Investment horizon

FD tenure generally ranges from 7 days to 10 years. An investor can select an investment period as per individual needs. The minimum deposit amount required in FDs is Rs.1,000 with most banks. Liquid funds have a short maturity period, usually up to 91 days. Here too, the minimum amount of investment is Rs.1,000. 

Taxation

Tax-saving FD investments are eligible for tax deductions under Section 80C of the Income Tax Act. However, FD returns are taxable at your slab rate except for senior citizens who are allowed a rebate of up to Rs 50000 on FD & Savings Bank interest. 

To avail of tax benefits, one must invest in an FD that has a maturity period of 5 years.

In the case of investment in Liquid funds, long-term capital gains are taxable at 20% with indexation, whereas short-term capital gains are taxed as per individual tax slab rate. 

How to choose between liquid funds vs FD?

The investment purpose for FDs is different from liquid funds. The returns offered by FDs can barely beat inflation. However, the trade-off here is higher safety against lower returns and strict lock-in periods. 

In case of liquid funds, investors can fetch better returns and higher liquidity than FDs. Liquid funds also provide the indexation benefit, since the purchase price gets adjusted to incorporate inflation. Whether to opt for liquid mutual funds or FDs will always remain a matter of debate among conservative investors. However, investors are fast becoming aware of the wealth maximisation opportunities that liquid funds can offer over FDs.

In the end, the decision on where to invest depends on an investor’s portfolio composition and wealth creation goals. 

Conclusion

Given the high liquidity and low-risk characteristics of liquid funds, these make for a reliable investment tool. It is important to educate oneself about the pros and cons of liquid funds as well as FDs before selecting one. Investors must aim for long-term wealth creation through a mix of investments within their portfolio. This can also balance out the overall risk levels.

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