When we think of safer investment avenues, fixed deposits (FDs) come to mind. For decades, FDs have been a part of every Indian family’s savings. However, we have seen a decline in FD rates in the last few years. This has led to a noticeable shift towards debt mutual funds.
This article will talk about debt mutual funds and the differences between debt mutual funds and FDs .
What are debt mutual funds?
A debt mutual fund is a broad category of mutual funds that invests in debt securities, such as government bonds, corporate bonds, treasury bills and commercial papers. These underlying instruments offer a coupon rate or fixed interest to their investors.
The aim of debt mutual funds is capital protection and it provides regular income to the investors. We can classify debt mutual funds into several subcategories, and the underlying debt securities of these debt funds also vary.
Depending on your investment horizon and risk tolerance, you can choose debt funds of your choice.
Differences between debt mutual funds and FDs
Debt mutual funds and FDs belong to the debt part of our portfolio. However, FDs and debt mutual funds are not similar and have several differences between them.
Here are some key differences between debt mutual funds and FD:
Returns:
Fund houses cannot guarantee debt mutual fund returns as the returns are linked to the market. While the returns may not be as volatile as equity funds, several factors like changes in the repo rate or other macroeconomic factors, such as GDP data and inflation figures may sway the debt mutual fund returns.
However, this is not the case with FDs. Banks give a fixed interest rate on FDs. While banks may revise the FD interest from time to time, once the FD gets booked, it will provide the promised interest rate till maturity. So, we can say that FDs are safer than debt mutual funds. But is it really safe?
Real returns:
FDs offer a fixed rate, but is it worth it?
Real return is the return generated by an investment option after subtracting the tax. In the case of FD, the bank interest rate is pre-tax. So, when you remove the tax, you end up with much lower returns. Given the high inflation rate and the tax on interest on FDs, the amount you receive is usually far less than what you expected.
On the other hand, debt funds have the potential to generate higher real returns than FDs. When you invest in debt funds, you only have to pay tax after redeeming your investments. Moreover, inflation growth is considered while calculating tax after staying invested in a debt fund for at least three years. This is called indexation. FDs do not offer the benefit of indexation.
Taxation:
Debt mutual funds are tax-efficient as compared to FDs.
You have to pay Short Term Capital Gains (STCG) tax and Long Term Capital Gains (LTCG) tax when you redeem your debt mutual fund units before three years and after three years, respectively. If you redeem your debt mutual fund investments before three years, the gains are added to your income, and it is taxed accordingly. In case you withdraw your investments after three years, a flat rate of 20% along with indexation benefits will apply. Indexation considers the growth in inflation. So, you only pay capital gains if the rate of inflation is lower than the fund's rate of return.
In the case of fixed deposits, the interest is categorised as income from other sources. As a result, we have to add the income to your total income, and your income tax slab determines the tax burden. Moreover, Tax Deducted at Source (TDS) also applies if your FD interest exceeds ₹40,000.
Investment Options:
Just like any other mutual fund, you can invest in a debt mutual fund by making lump sum investments or setting up a Systematic Investment Plan (SIP). However, you can only opt for a one time investment while booking an FD.
Liquidity:
Debt mutual funds are highly liquid than FDs as you can withdraw from an open-ended debt mutual fund at any time. However, FDs come with a maturity period. And, you may have to pay the fine for breaking your FD before the maturity date.
Conclusion:
In this blog post, we have understood the differences between debt mutual funds and FDs. FDs and debt funds have their own features. Overall, debt mutual funds have many advantages over FDs. However, it would help if you considered your risk tolerance, income tax bracket, time horizon, and investment objectives before deciding.