Liquid Fund vs FD – Understanding the key differences
Fixed Deposits (FDs) have been reliable investment avenues since decades. You already know how much extra money you will get when the FD matures. Another lucrative investment avenue is Mutual Funds. Over the years, Mutual Funds have gained immense popularity due to the returns they generate and their flexible onboarding methodologies. Liquid Fund, a type of Debt Mutual Fund, and Fixed Deposits have similar risk profiles and are usually preferred by investors with low-risk appetites. Here, we compare Liquid Funds vs FDs and understand whether one is better than the other.
A Liquid Fund is a type of Debt Fund that invests in fixed income instruments like bonds, money market instruments, corporate debt securities, treasury bills, commercial papers, etc. Liquid Funds come with a maturity period of 91 days and generate varying returns but have no lock-in periods. Therefore, you can redeem them at your discretion.
Fixed Deposit is a type of deposit account where your funds are parked for a predetermined amount and tenure at a fixed interest rate. Banks and non-banking financial companies (NBFCs) typically offer a relatively higher interest rate on FDs. You must stay invested in an FD for the chosen tenure. Otherwise, the provider can levy premature withdrawal charges.
With a Liquid Fund, your fund manager invests your money in short-term debt instruments with maturity periods not exceeding 91 days. After subscribing to the preferred Liquid Fund, you have the option to exit from the fund at any time, including the very next day following the investment. However, if you exit within the first six days, a graded exit load approved by the Securities and Exchange of India (SEBI) shall be applicable. You can redeem your invested money from the seventh day without penalties. Exit load is the charge that fund managers levy if you redeem a Mutual Fund before its intended expiry.
When it comes to Fixed Deposits, you can invest a fixed lumpsum amount in a deposit account with a bank Your interest earnings do not fluctuate with market conditions. Depending on your chosen tenure, you can earn periodic interest income (monthly/quarterly, etc.) or opt of cumulative interest payment when the deposit matures.
You can also withdraw the FD before its stipulated maturity date. However, banks and NBFCs offering FD facilities typically levy a withdrawal penalty, in the form of specific percentage of interest rate.
The only similarity between a Fixed Deposit and a Liquid Fund is the low-risk profile. With Fixed Deposits, you can earn interest ranging from 3% to 7% depending on the bank offering the FD facility and your chosen FD tenure. Regardless of whether the marker is falling or rising, the FD interest rates do not change.
Your fund manager invests your Liquid Mutual Funds mainly in debt securities while a small portion gets invested in equity. The fund earns interest from the debt holdings and capital gains from equity holdings. Note that Liquid Fund returns are not guaranteed. However, due to their shorter maturity periods, they are less prone to extreme market volatility.
Both Fixed Deposits and Liquid Funds are reliable investment instruments for investors with lower risk appetites.
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When you place funds in a bank for extended duration, the bank rewards you in the form of interest income. These FD interest rates have no correlation with the market. Overall, the risk of investing in FD is minimal to zero, as you get your lumpsum, capital investment back when the FD matures.
A small portion of your Liquid Fund investment does get invested in equities to balance the change in returns from debt instruments. Since a small aspect of Liquid Funds depends on market conditions, there is some risk involved. Thus, Liquid Funds are generally low-risk instruments but they are comparatively riskier than FDs.
FD interest rates vary across banks,=and FD tenures. The base rates are fixed by the Reserve Bank of India (RBI) from time to time. At the time of FD account opening, you can view the different interest rates for different tenures. You can also find out how much interest you will earn upon FD maturity using an FD Calculator.
Liquid Fund returns are not guaranteed. They can be lower or higher, depending on the market conditions. When it comes to Liquid Fund vs FDs, historical data has often put the former on top. Regardless, it is impossible to accurately predict Liquid Fund returns. For instance, a black swan event like a sudden market collapse due to political changes in another country can lead to negative Liquid Fund returns. Hence, diversification of your investment portfolio is imperative.
You can invest in an FD for tenures starting from seven days. The maximum tenure is generally five years to ten years, depending on the bank.. On the other hand, there are no restrictions for how long you should stay invested in Liquid Funds.
Per the Income Tax Act, 1961, interest income from FDs is taxable. Moreover, if the interest earned exceeds INR 40,000*, the bank levies a tax deducted at source (TDS) of *. If you do not hold a permanent account number (PAN), the TDS percentage becomes 20%*. For senior citizens above 60 years old, the TDS-free income threshold in INR 50,000*
Returns from Liquid Funds held for more than three years are considered long-term capital gains (LTCG). LTCGs are taxed at . If you hold Liquid Funds for three years or less, the returns are considered short-term capital gains (STCG). STCGs get added to your taxable income and are taxed per your income tax slab.
*Note that all such tax implications are according to the prevailing policies and therefore, are subject to change.
Both Fixed Deposits and Liquid Funds are investment instruments that play a different role. The two may have similar risk profiles, but Liquid Funds sway with market conditions while you can estimate the exact returns from your FDs at the time of investment. Diversifying your portfolio, however, allows you to enjoy the best of both worlds. FDs ensure that the market poses no risk to your funds while you can enjoy relatively greater returns with Liquid Funds.
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*Disclaimer: This article is for information purposes only. We recommend you get in touch with your income tax advisor or CA for expert advice.