When you have some savings, you can either:
- Buy something for a certain value and hopefully sell it for a higher value after some time: things like shares of companies (either directly or through an equity mutual fund), property, or commodities like gold and silver; OR
- Lend it to someone else and earn interest income while you wait to get the money back later: through a bank savings account, a bank fixed deposit or corporate/government bonds (either directly or through a debt mutual fund).
In this article, we’ll focus on the second one.
Lending money involves two entities – a lender and a borrower. The lender doesn’t need the money now, but the borrower does. The borrower pays the lender a fixed regular payment called “interest” for the privilege of having the money now. Once the borrower repays all the money borrowed, the loan is closed. Other words for “loan” are “credit”, “debt”, “bond” and such investments are also called “fixed income” since everything is fixed up-front (interest rate, repayment period, borrower, lender).
The most common example of a lending or a debt investment is your bank savings account or fixed deposit.
You lend your money to a bank in exchange for regular interest payments (after income tax). The bank then lends that money at a higher interest rate it to other people or companies to buy homes, cars, things, holidays etc. The bank makes the difference in rates (their “margin”) after writing-off the loans it is unable to collect on (called “credit risk”).
Another example of a debt investment is a debt mutual fund.
You buy units at a certain net asset value (NAV) or price, and sell it for a higher price in the future. You earn the difference after paying taxes on the gains. The money you invest is used by the mutual fund to buy a mix of government or corporate bonds that pay regular interest. Governments borrow for various social initiatives like infrastructure, defense, health schemes etc. when they haven’t collected enough money through taxes. Companies borrow for things like new factories or working capital (pay vendors now while waiting for customers to pay later).
As you can see, lending money to our bank is the default thing we do without even realizing it. It’s not completely risk-free: banks could make bad loans with your money and struggle to recover it back. However, its nearly risk-free because bank failures rarely happen and usually the government steps into the rescue. In exchange for this safety, we pay a steep price in terms of the return (interest) we get.
That’s why we, at Scripbox, recommended debt mutual funds as a place to park your emergency funds (six months of your monthly expenses) or for your short-term needs where you need the money back within five years (change of vehicle, a foreign holiday, master’s degree etc.). In the next article, we’ll look at what determines the price or NAV of a debt mutual fund, and how much return (over your bank account) you can expect.