There are many times when your funds are lying idle in your savings account. Suppose you need funds for a vacation in June but have already accumulated the wealth by January. Now you can either keep the funds in your savings account at a very low-interest rate or invest them for a short period to gain higher returns.
But it is important that you invest in a safe option so as to not lose your principal amount.
In such a case, you can invest your money in fixed deposits or look at liquid funds.
Let's understand how these two work
Fixed Deposits
It is an investment instrument offered by banks and NBFCs which gives you a predetermined rate of return for a specified period of time. Though the rates are not very high, it's better than what your savings account offers. In a fixed deposit, you can fix your money for a tenure of as low as 7 days to as high as 10 years depending on the time you have.
Interest rates in an FD vary depending on the tenure. You get a higher rate for a longer tenure.
Liquid Funds
A liquid fund is a debt instrument that invests in fixed income instruments like treasury bills, government securities, commercial papers, etc. It offers a maturity of a maximum of 91 days and is also a good option for short-term investment.
It aims at providing capital protection to investors and generating better returns than a savings account. Hence, they invest in high-quality instruments only.
FD vs Liquid funds
One of the key differences between the two is that FDs have a predetermined rate of return whereas liquid funds invest in money market instruments and hence their rate of return may vary depending on market factors. Due to this, liquid funds generally offer a higher rate of return than FDs.
It has a higher risk component compared to FDs but a lower risk component among mutual funds or trading.
Another main difference is that fixed deposits have a lock-in period. While you can withdraw your money prematurely, it attracts penalties. On the other hand, liquid funds offer more liquidity. You can redeem your units anytime you want after 7 days without any exit load.
While FDs offer a tenure from 7 days to 10 years, the maturity for a liquid fund is 91 days. If you do not want to withdraw after 91 days you can reinvest.
Taxation
The interest earned from your FDs is added to your taxable income and taxed as per your income tax slab. However, the bank/NBFC also deducts a 10 percent TDS when your interest is paid out.
In the case of liquid funds, if you hold them for over 3 years, long-term capital gains tax is applicable on them. They are taxed at 20 percent after indexation. Meanwhile, if you redeem them within 3 years of investment, the interest accrued is added to your taxable income and taxed as per the IT slab.
Both FDs and liquid funds have certain pros and cons. So, how do we decide between the two?
Who should invest in an FD
FDs are a preferred choice for investors with extremely low-risk tolerance. As FDs are offered by banks, they fall under the purview of the RBI and hence are one of the safest forms of investment. However, if you invest in an FD from an NBFC, make sure to check its CRISIL rating. Also, since the return is higher when the money is fixed for the longer term, it may be less beneficial in the short term. You can also gain some tax benefits if you invest in an FD for 5 years.
Who should invest in liquid funds
Liquid funds are a good option for investors who want to park their idle cash for the short term. While they don't have a fixed rate of return, they usually generate better returns than your savings account as well as FDs. However, they are a bit riskier than FDs.
While fixed deposits and liquid funds are both good options for low-risk investments, they have different features that make them ideal for different types of investors. You must consider your risk appetite and financial goals before choosing one.