Fixed Deposits v/s Debt Funds: Which Is a Better Investment Option?

December 15, 2021 Mutual Fund

To grow your wealth and financially secure your future, several banks and Non-Banking Financial Companies (NBFCs) offer a plethora of financial instruments you can invest in. Traditionally, many conservative investors opt for Bank Fixed Deposits (FDs) to park their savings and grow wealth. However, there is increased awareness about debt mutual funds over the last decade and more has catalysed a shift, and now many investors are opting for such funds. Continue reading if you are still befuddled about whether to invest in a Fixed Deposit or Debt Fund.

What are Fixed Deposits?

Fixed Deposits (FDs) are also known as ‘Time Deposits’ or ‘Term Deposits’ offered by banks and Non-Banking Financial Companies (NBFCs). It lets you deposit the money in a lump sum for a certain period of time at a higher rate of interest than a regular Savings Account. Some of the key benefits of a Fixed Deposit are:

• The Bank FD is considered the safest investment option. It is ideal for conservative investors who have low/ zero risk tolerance, are close to their retirement phase, or need to make an investment to avail of the tax benefits.

• The rate of interest of a fixed deposit is guaranteed and does not fluctuate with the market conditions. Even if the bank/ NBFC changes the rate of interest for that particular term, they are bound to pay you the same rate of interest they had offered at the time of making a fixed deposit.

• You can deposit your savings for a term (duration) based on the available fixed deposit tenures of the banks/ NBFCs, which generally ranges from 7 days to 10 years.

• The rate of interest of fixed deposits range between 4% to 6% p.a. You receive the interest on the deposited amount for a decided term.

• You can opt for a cumulative interest payment or periodic interest payment (monthly/ quarterly/ half-yearly/ yearly, etc.), as per your requirements.

• Although you can prematurely withdraw the money invested in a fixed deposit, the bank generally charges a penalty for it. The bank/ NBFC may charge 0.5% to 1% of the rate of interest of the period for which the deposit remained with the bank/ NBFC.

• You cannot avail of the tax benefits unless you have invested in any Tax Saver Fixed Deposit that has a lock-in period of 5 years.

• In case of a financial emergency, instead of prematurely withdrawing the FD, you can avail of a Loan Against Fixed Deposit. This way you will not have to terminate the fixed deposit; and you can get a loan of up to 90% of the FD amount.

• You can compare the rates of interest of various banks/ NBFC online and book it within a few minutes after completing the Know Your Customer (KYC) process. The KYC completion is mandatory for new customers. There are various types of fixed deposits based on several categories. Some of the examples of the types of FDs are: regular FD, Company FD, Employee FD, Senior Citizen FD, Tax Saver FD, NRI FD, Children's FD, Cumulative FD, Non-Cumulative FD, etc.

• Upon maturity, an investor can withdraw their funds, and then transfer them to a saving account, reinvest the entire amount, or reinvest only principal. The reinvestment can be customised as per your new requirements, i.e. you can reduce or extend the term, change the interest payout option, change the type of FD, etc. Senior citizens are generally offered a 0.5% extra rate of interest by banks.

Here are five finer points you should take care of before booking an FD:

• Know the type of fixed deposit that suits your financial plan.

• Compare the rates of interest of multiple banks/ NBFCs. When the amount is high, a small change in the interest rate can make a considerable difference.

• Check if the bank/NBFC provides good customer service.

• Check if the processes and internet banking or mobile app are user friendly.

• Check the ICRA and CRISIL ratings of the bank/ NBFC before making an FD.

What are Debt Funds?

Debt Funds are a type of mutual funds that primarily invests in fixed income generating instruments, such as government bonds, treasury bills, corporate bonds, certificates of deposit, etc. Hence, debt funds are the closest to fixed deposits in terms of risk and returns.

• Since most debt funds invest in fixed income generating instruments and the returns are not affected by the external market fluctuations, these are considered as a low-risk investment option.

• Debt funds do not have a lock-in period for staying invested, but some can have an exit load for the amount withdrawn before a certain time.

• The returns on debt funds can be 3% to 9% p.a.

• The debt funds are aimed to provide the investors with a steady income.

• Debt funds invest in financial instruments that have a maturity date.

• The returns on debt funds are not guaranteed.

• You can either invest a lump sum amount or start a Systematic Investment Plan (SIP), where you can invest a fixed amount every month.

• Debt funds are suitable for investors with a short or medium-term financial goal with a low-risk appetite. Even if you invest in medium to high-risk investment avenues such as equity funds and stocks, investing a portion of your total investment in debt funds can reduce the overall risk and generate promising returns.

• The various types of debt funds available are Liquid Funds, Dynamic Bond Funds, Money Market Funds, Guilt Funds, Fixed Maturity Plans, etc. Thoroughly research to choose the right type of debt fund for your financial goal.

• In case of a financial emergency, you can avail of a Loan Against Mutual Funds by pledging your mutual fund units, instead of prematurely withdrawing the fund.

• Lastly, bear in mind that the fund houses charge a fee for managing the fund, i.e. Total Expense Ratio, usually calculated by dividing the total fund costs by total fund assets. This can affect your returns.

Difference between Fixed Deposit and Debt Funds:

Comparing the fixed deposit and debt funds and understanding the similarities and differences can help you choose the right investment avenue for your financial plan.

• Guarantee of Returns:

  The fixed deposits offer guaranteed returns, whereas there are no guaranteed returns on debt funds.

• The Rate of Returns:

  The rate of interest on fixed deposits can be anywhere from 4%-6% p.a., depending on the bank or NBFC you choose. Whereas, the returns on debt funds are market-linked and may be anywhere in the range of 3%-9% p.a., depending on the type of debt fund scheme you choose.

• Regular Income:

  You can have a regular income (monthly/ quarterly/ half-yearly/ yearly) from both investment options. You earn interest on fixed deposits and dividends on debt funds. However, you should remember that the dividend income is not guaranteed.

• Risk:

  Fixed deposit is a low-risk financial instrument, whereas debt funds carry low to moderate risk.

• Liquidity:

  Both the investment options have liquidity. To avoid any premature withdrawal charges or exit load, it is crucial that you select the tenure and plan thoughtfully considering your liquidity needs.

• Charges on premature withdrawal:

  In case of a premature withdrawal of a fixed deposit, the bank/ NBFC charges with premature withdrawal charges. But, in case of a premature withdrawal of debt funds, you may or may not be charged the exit load, depending upon the type of debt fund you have invested in and your holding period.

• Type of investment:

  The fixed deposit allows investment only in a lump sum. But, for a monthly investment, you can opt for a Recurring Deposit (RD), which offers the FD rate of interest. In a debt fund, you can invest either a lump sum or via SIP.

• Charges:

  There are absolutely no charges for fixed deposits, but there is a nominal Total Expenses Ratio charged for managing the debt funds.

• Tax Benefit:

  You can avail of a tax benefit of up to Rs 1.50 lakh per financial year under Section 80C of the Income Tax Act, 1961, only on the Tax Saver Bank Fixed Deposit that comes with a minimum tenure of five years and does not qualify for premature withdrawal. However, investments in debt mutual funds are not eligible for such tax benefits.

• Loan Facility:

  During a financial crunch, you can avail of a Loan Against Fixed Deposit or Loan Against Mutual Funds. This will not interrupt your investment and you get the funds at a comparatively lower rate of interest without breaking your investment.

To Conclude:

Fixed deposits could be the right type of investment option if you require guaranteed returns for the short to medium term with no or low risk. But, if you are willing to take low to moderate risk, investment in debt funds can generate higher returns than fixed deposits for short or medium-term financial goals. Moreover, debt funds are a good option to diversify your portfolio with low-risk investment avenues that have high liquidity. Remember that although debt funds offer higher returns compared to fixed deposits, they are not 100% safe like fixed deposits. Furthermore, before investing in a fixed deposit or debt fund, it is essential to create a robust financial plan, define your investment objective, assess your risk appetite, and choose the right type of fixed deposit or debt fund to achieve your financial goals.

This article first appeared on PersonalFN here