Should you invest in Liquid Funds or Fixed Deposits?

7 MinsJuly 27, 2022

For a risk-averse or conservative investor, looking for capital preservation and modest returns, two suitable investment options are Liquid Funds and Fixed Deposits. These avenues provide a sense of financial security. Even for risk-takers, it makes sense to invest some portion of your portfolio tactically in Liquid Funds or Fixed Deposits, especially when equity markets are volatile. These instruments offer liquidity to sail through challenging times.

Should you invest in Liquid Funds or Fixed Deposits?

Key differences between Liquid Funds and Fixed Deposits

Distinction FeatureLiquid FundsFixed Deposits
ReturnsMarket-linkedFixed interest
RiskLow-to-moderate (depending on the portfolio characteristic of the schemes)Low (comes with DICGC insurance cover up to Rs 5 lakh per bank)
LiquidityVery highHigh
Suited investment horizonUp to a yearYou can choose from 7 days to 10 years
TaxationGains are subject to Capital Gain TaxInterest is taxable as per one’s income-tax slab

Let’s understand Liquid Funds and Fixed Deposits in detail.

Liquid Funds
These funds are categorised as debt mutual funds. The primary objective of a Liquid Fund is to provide optimal returns with a low-to-moderate level of risk and high liquidity through investments in money market and debt instruments.

Typically, a Liquid Fund invests in securities such as Commercial Papers (CPs), Treasury Bills (T-Bills), Certificate of Deposits (CDs), and other debt instruments that have a maturity of up to 91 days. The nature of these securities and the short maturity, safeguard Liquid Funds from interest rate fluctuations. That is why Liquid Funds are placed at the lower end of the risk-return spectrum in comparison with the other debt mutual funds. Therefore, if you are looking to park your money for the short-term, or want to build an emergency fund, then Liquid Funds may be a worthwhile option.

Having said that, there is some element of risk in Liquid Funds. It depends on the kind of securities the fund holds in its portfolio. If the fund holds securities of private issuers, then depending on their rating, you could expect low-to-moderate risk. Hence, it is important to check the portfolio characteristics of a Liquid Fund before investing

[Also ReadHow Fixed Deposits help during market volatility]

Points to remember when investing in a Liquid Fund:

  • Ideally, look for a Liquid Funds that invests in government/quasi-government securities, Treasury Bills (T-Bills), and AAA/A1+ rated Public Sector Undertakings.
  • Avoid funds with exposure to corporate papers having high credit risks.
  • The portfolio should be well-diversified across a range of securities and it should be concentrated towards a certain company or group of companies.

Taxation of Liquid Funds
Since it is a debt fund, a Liquid Fund is subject to Short-term Capital Gains Tax if held for less than three years and taxed as per your income tax slab. If the holding period is more than three years, then the gains are subject to Long Term Capital Gain (LTCG) tax at the rate of 20% with indexation benefit.

Fixed Deposits
As an investor, if you are looking to earn steady, secured (DICGC insurance cover of Rs 5 lakh per bank for deposits), and fixed returns in the form of interest (without being exposed to market-linked risk), Fixed Deposits (FDs) –– also known as Term Deposits –– are one of the best-suited avenues for you.

By investing in FDs, you can meet your financial goals, save for a rainy day, and save tax (with a 5-year tax-saver FD).

If you don’t have a lump sum amount to invest in FDs, you can invest small amounts monthly in a Recurring Deposit and enjoy the same benefits.

When investing in FDs, choose your tenure and pay-out option thoughtfully. For example, if you are planning for a financial goal, that is 2 or 3 years from now, and you do not require interim cash flows in the form of monthly or quarterly interest pay-outs; opt for the cumulative plan (also known as the reinvestment of interest plan).

On the other hand, if you are a retiree who needs cash flows in the form of interest income (to pay certain household utility bills and take care of other expenses during retirement), you may choose the monthly or quarterly interest pay-out plan as per your suitability. Being thoughtful may help you earn decent returns as well as take care of your liquidity needs.

Here are some ground rules to maximise returns on the FDs:

  • As far as possible, choose the cumulative (also known as the reinvestment of interest) plan if monthly or quarterly interest pay-out isn’t your requirement.
  • Follow the FD laddering strategy, wherein you spread your lump sum investment across maturities paying heed to your liquidity needs. In times when interest rates in the economy are likely to move up, this will potentially help you earn better returns
  • As much as possible, avoid premature encashment of the FD, as doing this would put brakes on the power of compounding. Instead, when in need of money for whatever purpose, consider availing of a loan against your bank FD.
  • And at maturity, if you don’t require the money immediately, renew the FD for the desired period. This will support the power of compounding and help you build a bigger corpus.

To know how much returns your investment in a bank FD will earn, use axis Bank’s FD calculator.

Taxation of FDs
Also, note that interest earned on FDs is taxable. To avoid TDS, you may furnish a declaration under Section 197A of the Income Tax Act in Form 15-G (for general or non-senior citizens) or Form 15-H (for senior citizens), as applicable, to the bank.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision

Mutual Fund investments are subject to market risk, read all scheme related documents carefully. Axis Bank Ltd is acting as an AMFI registered MF Distributor (ARN code: ARN-0019). Purchase of Mutual Funds by Axis Bank’s customer is purely voluntary and not linked to availment of any other facility from the Bank. *T&C apply

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