Fixed Deposits vs Debt Funds

Mutual Funds vs Fixed Deposits; where to invest ?

When it comes to saving money, people often opt for fixed deposits, considering them to be relatively risk free.  The security of having the money in the bank is apparently a great factor. But we need to introspect that is this actually saving of money or rather losing of it? Fixed deposits of FDs may give attractive returns on paper, but with the tax payable at the current tax slab, the more one invests in FDs, the more tax one has to pay. Taking in consideration the rate of inflation over the years, it is possible that one may actually be facing a loss by investing in FDs. 

Debt funds have become very popular in the past few years and many people had starting shifting funds from Fixed Deposit to Debt Funds as the tax levied was very low on income from Debt Funds as compared to Tax on Income from Fixed Deposit

What is a Debt Fund ?

A debt Fund is a professionally managed fund which invests in highly rated fixed income earning instruments like Govt Bonds, RBI Bonds, Money Market Instruments and Certificate of  Deposits etc. The pool of investment is collected from the public and this investment is in-turn invested in highly rated fixed income earning investments with low risk & managed professionally.

Let us compare some features of Fixed Deposits vs Debt Funds :

1. FDs offer assured returns but debt funds offer higher post-tax returns

When you place an FD, the interest rate gets locked. It’s currently 7.75% to 8.25% for FDs above a year. You can accurately predict the amount of money you will have at the time of maturity even before you start the FD.

Debt funds also provide 8-9% returns when you look at the historical debt funds’ performance. However, returns for debt funds are not guaranteed. While debt funds are mostly safe investments, there could be some volatility due to the fluctuations in interest rates. Some debt funds react more to these fluctuations than others and once again, with careful analysis, you can pick those with low volatility.

2. Taxes significantly affect income from FDs

The income you earn from FDs and debt funds is categorized differently. You earn interest from FDs while debt funds give you capital appreciation or dividend.

While interest from Bank FDs is always taxed at your maximum rate, Debt funds attract almost nil tax after 3 years.

What hurts an FD investor even more is that they have to pay taxes on accrued interest every year (even if you haven’t actually received it in your hands) and therefore the amount of money which compounds is less.

3. Debt funds provide better liquidity or easy access to your money

Withdrawing from FDs

If you need your money back before the maturity of the FD, you will receive a lower rate of interest and also pay a penalty.

  1. Some banks allow you to break your FD in part but most require you to withdraw the whole amount. If you have INR 1 lakh deposit, but you only want INR 20,000, you have to break the entire FD.

  2. Interest Rate on premature withdrawal = Interest Rate applicable for actual period of FD as per the rates prevalent at the time of investment – 1%

  3. The penalty for withdrawing is 0-1.5% of the invested amount viz. Rs 0-1500 for a one lakh deposit.

Withdrawing from Debt Funds

With debt funds, you have full liquidity for your investments.

  1. You can withdraw any amount you wish to from your total debt fund value whenever you want. The money comes into your bank account in 3-4 working days.

  2. The return you get is the amount earned by the fund during the period you were invested. There is no complex formula.

  3. Some debt funds will charge you an exit load if you withdraw within a certain period of time. This is usually (0.50% – 1.0%) and only for periods between first to third year.

4. Burden of tax related paperwork is higher for FDs

Since you must declare and pay taxes on interest income from FDs every year, you have to maintain records, compute your interest income and file taxes accordingly. This gets even more complicated in case of premature withdrawals where you may already have paid tax but the income you finally get is lower.

For debt funds, you only have to pay capital gains tax as and when you withdraw. This could mean only once in 5 years.

As you can see, with debt funds, you get superior returns post-tax, high level of liquidity, and safety of capital compared to FDs. These make debt funds an Excellent alternative to keeping your money in Bank FDs

Conclusion :

In case of the period of holding is short term i.e.less than 3 years ,both Debt Funds and Fixed Deposits are taxed equally and also levy the same penalty in case of pre mature withdrawal

However, in case the period of holding more than 3 years ,for individuals falling in the 30% income tax bracket –the tax on Debt Funds is lower than Fixed Deposits and no penalty is levied in case of pre-mature withdrawals as well

Therefore before investing in any of these forms of investments, it is important for the investor to decide that if he wants to invest in Debt Funds or Fixed Deposits. If he intends to invest for more than 3 years and he is in the 30% Income Tax Bracket-Debt Funds are advisable and if he intends to invest for less than 3 years-Fixed Deposits are advisable.

Click Here to know more about Debt Funds

Click Here to know more about Debt Funds Taxation.