New-age investment apps market the ‘liquidity’ aspect of liquid mutual funds as the USP for short-term parking of money or keeping emergency corpus. They tell you that unlike traditional bank FDs, liquid funds can be withdrawn as you like and score on returns and taxation too. But before basing your investment decision on such advertisements, here are a few key facts to note about liquid funds.

Liquid funds are debt mutual funds that predominantly invest in money market instruments with maturity up to 91 days. Consequently, these funds have relatively shorter duration than other debt funds

Here are some myths about liquid funds that we seek to dispel for you.

Returns not better than FDs

Dwindling interest rates of bank FDs have spurred investors to scout for alternatives with better returns. While liquid funds, in the past, did beat traditional FD rates and gave returns of 6-9 per cent for some one-year time periods, they have seen a sharp revision in rates now. With the central bank opting for monetary easing, the rates in money markets have tumbled to lows of 3-4 per cent. Past performance is not indicative of the future, and this holds true for this category of mutual funds as well.

With the RBI insisting on maintaining the repo rate at 4 per cent, the low returns on these funds are here to stay and the possibility of rates inching up from here on seems at least a couple of years away. Currently, the yield to maturity (YTM) of funds in this category is in the range of 3.15 to 4.68 per cent. Besides, they come with an expense ratio of up to 0.55 per cent (direct schemes). Despite the lower returns, liquid funds also don’t guarantee a said rate of return, unlike bank FDs.

While money market instruments often come with sovereign backing most of the time (T-bills and instruments offered by the RBI), their rates are still market-linked. So, while liquid funds eliminate a great deal of the default risk, some interest rate risk still remains. On the contrary, banks such as Kotak Mahindra Bank and IDFC First Bank offer interest in the range of 4 to 5 per cent on their savings bank account. Those of you looking for options to park your emergency funds, and are clueless about the withdrawal timelines, could consider these options. However, be mindful of the minimum balance requirements of such accounts.

If you have some clarity on the withdrawal timeline, you are better off considering a bank FD, even in the current low interest rate regime. For tenures of less than one year, bank FDs currently fetch you interest up to 5.75 per cent; for higher tenures of 2/3/5 years, banks offer interest in the range of 5 to 6.5 per cent per annum. Given these bank FD rates, investors should consider the risk-reward equation of exposing their savings to the market-linked nature of liquid MFs.

Withdrawals simpler?

It is not entirely true that liquid fund withdrawals are simpler compared to bank FDs. Agreed, bank FDs may prohibit withdrawals within timelines such as three or six months to a year, . But if you cross that timeline, withdrawals seem more hassle-free in bank FDs.

The instant access facility in a liquid fund comes with strings attached. This facility is only available on growth plans of liquid funds. Also, you can only withdraw up to ₹50,000 or 90 per cent of the latest value of investment in the scheme, whichever is lower, using instant access facility, in a day, from each scheme.

Beyond such limits, redemptions take up to one business day, compared to limitless instant credit to your savings account in the case of a withdrawal from a bank FD. Weekends and business holidays can further delay the credit of money in liquid funds, beyond such limits.

Investors are often told that liquid funds do not charge penalties on exits, unlike bank FDs. But this is a half-truth. Liquid funds do come with no lock-in periods and hence do not carry exit loads. However, do remember that exit loads are charged in the range of 0.0045 to 0.007 per cent for withdrawals from liquid funds within seven days of investment. Besides, do note that the exit loads are a charge on your corpus, unlike the penalty on premature withdrawals on bank FDs — where you only lose out a percentage of the interest that the bank initially agreed upon.

Not always tax-efficient

While the interest income on bank FDs is taxed under income from other sources at your slab rates, the returns on liquid funds are taxed as dividends (on dividend plans) or capital gains (on sale or redemption).

If funds invested are redeemed within three years, the gains (difference between redemption amount and investment value) are taxed as short term capital gains at slab rates — that brings them on par with traditional FDs.

However, gains on withdrawals beyond three years are taxed as long term capital gains at the rate of 20 per cent, after indexation. So, the tax efficiency of the instruments essentially depends on your current income tax slab rate and the investment horizon. Dividends earned from mutual funds are also taxed at slab rates. So, liquid funds are not always as tax-efficient as one would like to think.

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