Liquid Funds vs Fd- Why Liquid Funds are Better Than Fixed Deposits?

We all know that we need debt in our portfolio as it brings safety, stability and regular income. You obviously cannot put all your money in equities as then the risk in the event of downside would be just too high. But that is where the problem starts. You have a big choice of debt products like bonds, debentures, government securities, bank FDs, corporate FDs, mutual funds, liquid funds etc.

Figuring out where to invest can be challenging. Some people recommend fixed deposits are best, while some prefer investing in liquid mutual funds. It’s time for you to decide where you should invest- Liquid Funds or FD?

Always remember at the outset that FDs in the bank and liquid funds are not wealth creators. You can invest all you money in FDs or liquid funds through your life and still be left with nothing much. Wealth creation happens through equities but we will not get into that right now. When you want to keep your funds in a safe place for emergency needs or for other commitments. Here your main purpose is safety of principal and some returns, not wealth creation. It is very important that the funds are easily available without capital loss and are liquid enough. More importantly, capital has to be protected.

In India, investing money for a very long time was only limited to fixed deposits or recurring deposits, despite the rising popularity of mutual funds. This is mainly because these investments are the most trusted and they guarantee principal repayment without being exposed to the market fluctuations. People trust banks as they are backed by the government and there is deposit insurance. Although the FDs and RDs promise returns, it is liquid funds that can help keep your money liquid at a slightly higher yield. When the corpus is large, these small differences matter a lot.

Let’s understand FDs and Liquid Funds in much greater detail before identifying the best among the two. Here is a quick take on both the products.

Commercial banks and small finance banks offer fixed deposits, which is a way to keep your money safe, relatively liquid and also earn more than the savings deposit rate. It is the most common investment avenue for several people across the world. As per a data by Reserve Bank of India, the share of FD account was around 58.2%. FDs can also be easily pledged for getting loans from banks and other financial institutions.

On the other hand, liquid mutual funds are debt fund comprising of treasury bills, commercial papers, certificate of deposit, etc. It is also a very safe investment but there is an element of market risk in liquid funds. It normally invests in money market instrument with a maturity of fewer than 91 days. Despite the advantages that they proffer, there is still a very robust market or clientele for Bank FDs more because it is the basic relationship that every customer has with the bank.

Let us first look at how the bank fixed deposits and liquid funds compare on the risk factor. Remember that, fixed deposits have existed in the financial market for a long time because they are risk proof. Also, the principal is guaranteed by the government which is what makes it more attractive to many customers.

However, in the case of liquid funds, there is a moderate risk as the fund’s performance is subject to market risks, changing interest rates, etc. Liquid funds are not as vulnerable to interest rate changes like G-Sec funds but the market risk is still there. Liquid fund’s NAV depends on these factors; hence, opting for this type of fund can be a slight risk. Keeping the risk factor aside, you should also note that NAV of liquid funds can be subject to some pressures like we saw in the case of Templeton in 2020.

The interest rate on the FD account is mostly in the range of 4% to 5% for general citizens for tenures between 1 year and 5 years. For senior citizens they get a slightly higher rate. Your money will grow at a fixed interest rate throughout the tenure. Hence, it is not the best choice if you are looking for maximum returns.

Liquid Funds generate profits at the interest yields ranging from 5% to 6%. However, liquid funds are likely to offer better rates once the rates go up in the market. Till now, most funds have delivered positive returns on redemption. In return terms, the liquid funds have the advantage of about 100-150 basis points over the bank FDs.

The tenure of FD accounts ranges from 7 days to 10 years. You can choose the investment period depending on your needs and the minimum deposit amount should Rs.1000. However, on a 7 day FD, the interest rates are as low as 2.8% annualized.

Liquid Funds have a short maturity period, which is up to 91 days. You can start investing a minimum of Rs.1000 or a maximum of Rs. 5,000 monthly. In terms of time horizon it is a lot more flexible as this can be used for all kinds of time frames.

You’re entitled to get tax deductions under Section 80C of the Income Tax Act on Bank FDs, but that entails a necessary lock-in for five years. However, the interest component is taxable at your peak rate. SO, if you are in the 30% bracket, then the 5% yield on FD would actually be 3.5% net of tax. Also, there is TDS if your FD interest is more than Rs.10,000 per year, although this limit has been enhanced to Rs.50,000 for senior citizens.

When it comes to tax on liquid funds, the first thing you must remember is that these are treated as debt funds. If you opt for dividend plans, then your dividend is also taxed at your peak rate just like FD. Even short term gains, less than 1 year is taxed at peak rate. However, if held for more than 3 years, it is taxed at concessional rate of 20% with indexation benefits, which reduces the liability of tax further.

More importantly, you can structure systematic withdrawal plans (SWP) in the case of liquid funds, which is a lot more tax efficient.