Both liquid funds and fixed deposits are preferred financial instruments for parking short-term surpluses. As both of these instruments have their own set of pros and cons, it becomes important for investors to know the features of these financial instruments. Here is a brief comparative analysis of fixed deposits and liquid funds to allow you to make an informed decision about deriving optimum benefits.
Features of Fixed Deposits
Fixed deposit is the most popular financial instrument among new and risk-averse investors. Most banks offer additional interest rates to senior citizens over and above the regular FD rates offered to other depositors. Other features include loan or overdraft against deposits, multiple interest pay-out options, auto-renewal, etc. Let us discuss in detail:
Plans/Options Offered
Banks usually offer both cumulative and non-cumulative options while opening FD. Under the cumulative option, both the principal amount and the interest accrued are paid at the time of maturity. This option allows reinvestment of the interest component to the deposit amount and thereby, benefits from the power of compounding.
In the case of a non-cumulative option, the interest accrued is paid at periodical intervals – monthly, half-yearly, annual, or quarterly intervals. Individuals looking for daily income sources can opt for any of the mentioned interest payout schemes based on their financial requirements.
Also, individuals should use FD calculator to know their returns on different interest rates, cumulative/non-cumulative options, and deposit amounts. This will enable them to know their maturity amount in advance and determine whether the chosen FD scheme or interest rate serves their investment goals.
Taxation
Banks deduct TDS @10% if the interest income on fixed deposits exceeds Rs. 40,000 in a financial year. For senior citizen depositors, TDS @ 10% is deducted if the interest income exceeds Rs 50,000. Depositors should note that TDS @ 20% is deducted in case PAN details are not furnished to their respective banks/NBFCs.
According to Section 80C of the Income Tax Act, individuals can avail income tax deductions on Tax Saver FDs of up to Rs 1.5 lakh on the principal amount. However, tax-saver fixed deposits have a lock-in period of 5 years and no premature withdrawal facility is allowed during this period. Moreover, no loans/overdraft facilities are available tax savings deposits. Also, note that interest income on Tax Saver FDs is taxable as per the tax slab of the depositor and TDS-related provisions are also applicable.
Cost incurred on Premature Withdrawal
Both callable and non-callable options are available for fixed deposits. Banks allow depositors to withdraw their FDs under the callable option. Premature withdrawal is not allowed in non-callable FDs.
Depositors should note that banks usually charge a penal rate of up to 1% on premature withdrawal of FDs. The penal rate is deducted from the effective interest rate of the deposit. For most banks, the original contracted FD rate or the interest rate applicable on the tenure for which the FD remained with the bank, whichever is lower, would usually be the effective interest rate of the FD.
Risk
Compared to liquid funds, fixed deposits carry less risk. The depositor’s cumulative deposits of up to Rs 5 lakh are insured with DICGC, a subsidiary of the Reserve Bank of India. The cumulative deposits include savings accounts, fixed deposits, recurring deposits, and current accounts of the depositor. The insured amount covers both the principal and interest components of the bank deposits. This deposit insurance coverage limit is applicable separately with each bank if the depositor has deposits with multiple banks.
Features of Liquid Funds
Liquid funds, also known as debt mutual funds, invest in fixed income instruments with residual maturities of up to 91 days. Fixed income instruments include corporate bonds, commercial paper, treasury bills, etc.The returns generated by liquid funds depends on two factors – interest income and capital appreciation generated by their underlying securities.
Plans/Options Offered:
Investors have two options under liquid funds – Growth options and Income Distribution/ Capital Withdrawal options (IDCW). Under the IDCW option, Monthly IDCW (Payout & Reinvestment), Daily IDCW (Reinvestment) and Weekly IDCW (Payout & Reinvestment) are available wherein investors can opt for monthly, daily, or weekly dividends. Choosing the growth option would enable the investor to take advantage of compound interest while the dividend option would be more appropriate for investors who require regular cash inflows from their investments.
Exit Load
When a debt fund investor redeems their investment before the expiry of a pre-determined period, they are usually subject to a penal charge in the form of exit load. In the case of liquid funds, the exit load is usually levied on making redemptions within 6 days of making an investment.
Taxation
Redeeming liquid funds within 3 years of investment is subject to Short-Term Capital Gains (STCG) tax, which is computed based on the investor’s income tax slab. Prior to this financial year, liquid fund units redeemed after 3 years of investment were subject to a 20% Long-Term Capital Gain (LTCG) tax with indexation benefits. However, from this financial year, capital gains derived from redeeming liquid fund units after 3 years of investment would also be taxed as per the investor’s tax slab.
Risk
There are also some risks involved in liquid funds. Adverse changes in the underlying securities’ credit rating, as well as an increase in market and policy rates, could have a negative impact on the fund’s Net Asset Value (NAV). However, compared to other debt funds, the interest rate risk associated with liquid funds is minimal because of their shorter maturity profile of 91 days or less.
Bottom Line
For relatively short time horizons, liquid funds may offer higher returns than fixed deposits. On the other hand, the returns of liquid funds are market-linked and therefore, carry a slightly higher risk than fixed deposits. Keep in mind that during a falling interest rate regime, liquid funds usually generate higher interest rates as compared to bank FDs. However, in the case of bank failure, the DICGC insures cumulative bank deposits (including fixed deposits) of each depositor of each scheduled bank of up to Rs 5 lakh. As a result, customers opening fixed deposits with scheduled banks will have higher capital and income protection than liquid funds.
Fixed deposits are booked in for a specified tenure and early withdrawals are subject to penalties. Liquid funds, on the other hand, have no specific duration and only levy an exit load penalty if the units are redeemed prior to the 7 days of investment. Consequently, investors with longer investment horizons, a lower risk tolerance, and/or a preference for higher income certainty can consider fixed deposits. Liquid funds can be an option for those having a higher risk appetite and a shorter investment horizon while seeking higher returns and liquidity.
