Bank Fixed deposits had been a traditional source of investment for all of us. Investors prefer to protect their principal in return for lower interest rates. But, since the last few years, we saw a paradigm shift in investor's behavior especially millennials. They try to explore newer investment avenues to invest their hard-earned money. Debt mutual funds have emerged as a close rival to FD’s in terms of low-risk investment. There are several factors that make them look similar but there are differences in terms of tax implications, inflation-adjusted returns, liquidity, and safety.
If we compare returns between them, mutual funds deliver higher returns compared to fixed deposits. Investors consider credit risk (risk of default) as well as Interest rate risk (risk of changing interest rate to change in bond price) while investing in mutual funds and hence investors get higher returns for higher risk. Historically, with higher inflation, debt funds are able to beat inflation and generate higher inflation-adjusted returns compared to Fixed deposits. Thus, Debt Funds are a clear winner in terms of returns.
Fixed Deposits are taxed as per income tax slab of investors i.e. 30% in many cases. While Debt funds, if held for 36 months provides indexation benefit with a lower tax rate of 20%. Let us understand through example:
|Fixed Deposit||Debt Mutual Fund|
|Investments||Rs. 100,000||Rs. 100,000|
|Amount after 3 years||Rs. 125,971||Rs. 125,971|
|Indexed Cost of purchase||N/A||Rs. 119,102|
|Profit||Rs. 25,971||Rs. 6,869|
|Tax to be paid||Rs. 8,025||Rs. 1,374|
|Net Profit||Rs. 17,946||Rs. 24,597|
*Returns are assumed 8%, inflation 6% and tax rate 30%
Therefore, Debt Funds are a clear winner in terms of tax savings
Both Fixed Deposits and Debt funds have interest rate risk associated with them. But Fixed deposits are one of the safest investment vehicles available to investors with a very negligible amount of risk associated. While Debt funds are prone to credit risk. Risk differs among different funds you choose to invest. Thus, Fixed deposits are a clear winner in terms of safety.
Liquidity here refers to how easily you can sell your investments without any cost. In the case of Debt funds, you can withdraw your money anytime you want without any penalty (in the case when funds are held for more than a year), while fixed deposits are illiquid as it levies penalty if you withdraw prematurely. Hence, Debt funds are more liquid compared to fixed deposits.
Investors need to evaluate these factors before investing money. If tax rate, liquidity, and returns are important factors, undoubtedly debt mutual funds are a preferred choices. Generally, Debt funds are a better choice if you want to invest money for the short-term as well as for the long term.