Scripbox logo

Why Debt Mutual Funds Are An Excellent Alternative to Fixed Deposits?

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.

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.

Most Fixed Deposits are AAA rated Implying very high safety of capital. In other words you have a very low chance of losing the money you had invested.It is commonly assumed that FDs are guaranteed by the government. They are, but only to the extent of Rs 1 Lakh. Beyond that the credit rating of the bank comes into play and which bank you choose is important.

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. For example, Scripbox recommended portfolio of debt funds have most of their investments with a high credit rating.

#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. Scripbox selection methodology, for example, takes this into account.

#3: Taxes significantly affect income from FDs

The income you earn from FDs and debt funds is categorised 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. (you can read more about this effect here)

#4: 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 small (0.25% - 0.5%) and only for periods less than a year.

#5 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 the 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.

Still not convinced? Learn why FDs won't make you rich, anytime soon.
Send me email newsletter Subscribe
You have successfully subscribed.