We confidently recommend equity mutual funds as a suitable option for most people with a long-term investment horizon. However, there are situations where equity is not the most suitable asset class:
- Your goals are less than 5 years away; or
- Your growth objectives will be met with a lower (8-9%) rate of return; or
- You are not comfortable with volatility and willing to adjust your growth expectations accordingly.
If you are in this position, there are two convenient options for you: Bank Fixed Deposits and Debt Funds. In this article, we compare them on different criteria and evaluate which is better for you.
Bank FDs vs Debt Mutual Funds
#1: Safety of Capital is almost the same
To understand how safe your money is, you need to look at the credit rating of the instrument. This is given by Independent Credit rating agencies using the below scale.
| Rating | Typical Issuers | What it means |
| Sovereign | Government of India | As safe as it gets |
| AAA | Most banks, Public Sector Undertakings, Large financially stable private companies | Very high degree of safety |
| AA | Private Companies | High degree of safety |
| BBB | Private Companies | Below average |
| BB, B, C &Lower | Private Companies | Poor |
Debt funds are not themselves rated but their safety can be deduced from the portfolio they invest in - typically sovereign to AA. With careful analysis, you can pick debt funds whose portfolio has a combined credit risk almost at par with FDs.
#2: 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 8 to 9% 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.
#3: 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 and lower tax between 1 and 3 years. Upto 1 year the tax impact for both is similar.
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.
| Impact of annual taxes on Fixed Deposit Returns | |||||
| Debt Funds | FD | FD | FD | FD | |
| Return | 9% | 9% | 9% | 9% | 9% |
| Personal Tax Rate | Any | 0% | 10% | 20% | 30% |
| Start with | 100,000 | 100,000 | 100,000 | 100,000 | 100,000 |
| Year 1 | 109,000 | 109,000 | 108,100 | 107,200 | 106,300 |
| Year 2 | 118,810 | 118,810 | 116,856 | 114,918 | 112,997 |
| Year 3 | 129,503 | 129,503 | 126,321 | 123,193 | 120,116 |
| Year 4 | 141,158 | 141,158 | 136,553 | 132,062 | 127,683 |
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.
- 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.
- Interest Rate on premature withdrawal = Interest Rate applicable for actual period of FD as per the rates prevalent at the time of investment - 1%
- The penalty for withdrawing is 0-1.5% of the invested amount viz. Rs 0-1500 for a one lakh deposit.
With debt funds, you have full liquidity for your investments.
- 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.
- The return you get is the amount earned by the fund during the period you were invested. There is no complex formula.
- Some debt funds will charge you an exit load if you withdraw within a certain period of time. This is usually small (0.25% - 0.5%) and only for periods less than a year.
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.
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