The bank fixed deposit has been the most preferred choice for generations of investors who prefer low-risk instruments. On the other hand, it is turning out to be harder and harder to close your eyes to the benefits offered by debt funds. These two instruments are quite similar in functioning and are close contenders. The chief areas of difference between the two instruments are returns on investment, security, taxation, and liquidity.
Usually, debt funds are suggested as short to medium term investment options, and more often than not as a more beneficial substitute to the bank fixed deposits. When investors are investing their money in these kinds of instruments, their main concern is to safeguard their capital instead of focusing on great wealth creation.
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Before analyzing what is the difference between fixed deposit and debt funds, let us see what these two instruments really are:
In this article
- What is Fixed deposit?
- What are Debt funds?
- What Makes Debt Funds A Better Option As Compared To The Fixed Deposits?
What is Fixed deposit?
Fixed deposit is an amount of money provided to a bank, financial institution, or a company where the party that gets the money pays interest to the party who deposited the money at a pre-specified percentage for the time length of the deposit. When the time period of the deposit ends, the deposit amount that is initially given is repaid to the investor. Fixed deposits are also acknowledged as term deposits.
Over last few decades, fixed deposits have been a very popular option amongst the small investors. But then again there are a few things that you should know about fixed deposits before you make any decision regarding investing in them. Here are a few things to know about fixed deposits:
Interests are paid on either monthly or three-monthly basis.
The fixed deposit interest is generally paid on either monthly or quarterly basis based on the preference of the investor.
For example, an individual who invests Rs 1,50,000 in the plan for one-year fixed deposit with the interest rate of 8% per annum will receive Rs 1,000 per month i. e. 8% of Rs 150000 will be divided by 12 (for 12 months). Apart from that, the investor also gets a reinvestment option.
The return on a fixed deposit is quite different from interest received.
When an investor receives an interest rate of 8% p.a. on fixed deposit, it would mean a return of 8.24% in a year for those investors who chose to reinvest the interest.
It means that if you have invested Rs 100 at the start of the year, by the end of the year your investment will amount to Rs 108.24 as the interest received is compounded on a quarterly basis.
When you are receiving an interest of 8% per year, it means that you would be receiving an interest of 2% in a quarter. Hence, for Rs 100 invested, you would earn an interest of Rs 2 at the end of the first quarter. Therefore, at the end of the first quarter, the investment of Rs 100 would become Rs 102. As this interest will be reinvested, for the next quarter, you will earn 2% interest on Rs 102 and the interest received would be Rs 2.04. After reinvesting this interest, you will earn an interest of 2% on Rs 104.04 for the next quarter.
Continuing this process until the end of the year, you will be able to accumulate Rs 108.24 and as a result, you will be receiving a total return of 8.24%, which will be higher than 8% p.a. If you have additional funds with you, and you are putting that extra money in a fixed deposit, it will be a sensible choice to opt for the reinvestment of interest and earn a higher return.
Be careful when breaking your fixed deposit.
Let’s say you want to break your fixed deposit. Maybe because you need the money instantaneously or because other banks have begun offering a higher interest rate on the fixed deposit. Breaking a fixed deposit will cost you something.
Many banks provide on premature withdrawal an interest rate 0.5 % lower than the interest rate applicable at the beginning of the deposit period. For example, an individual deposit the money for three years with an interest rate of 9% per annum.
Due to some unavoidable circumstances, if you have to break your deposit at the end of the first year, the bank will pay you an interest of 8.5 % for a period of one year, but you will be receiving an interest of 0.5% less than 8.5% that is 8%.
Interest earned on fixed deposit is not tax-free.
The interest that an investor earns on the fixed deposit comes under taxable income and is taxed as per the tax bracket that an individual investor’s earnings fall into.
You can raise loan against the fixed deposits.
If you have invested in fixed deposit, you can raise the loan against your deposit. It is an inexpensive way and requires a very little paperwork.
What are Debt funds?
A debt fund is a pool of investments, for instance, a mutual fund or exchange-traded fund, in which the main assets are fixed-income investments. A debt fund can put money in short-term or long-term bonds, money market instruments, securitized products, floating rate debt etc. On an average basis, the fee percentages on debt funds are lesser than equity funds for the reason that the total management costs are lower there.
Debt funds provide several benefits but then again retail investors hardly know anything about them. Given below are a few points that you should know about debt funds:
Before investing in a debt fund, it is important to know what tax rules are, where the debt funds are concerned. You must find out what is the minimum term period for long-term capital gains so as to take advantage of lower tax on long-term capital gains.
No TDS involved
One of the other tax benefit features of the debt fund is that there is no tax deduction at source (TDS) involved on the gains earned.
Returns are based on market circumstances
Although the debt funds look very favorable, they do not provide guaranteed returns. Indeed, they can lead to losses if the interest rates increase, even though the likelihood of this happening is far-flung. The maturity sketch of the assets or holding outlines the unpredictability of a debt fund.
However, debt funds with short-term bonds are not usually unstable and offer returns that are approximately similar to the usual interest rate.
On the other hand, the funds which have been invested in the long-term bonds, are somewhat more sensitive to vicissitudes in rates of interest. In case the rates come down, the worth of bonds in their portfolio goes up, resulting in higher capital gains for the investors.
Invest in Systematic Investment Plans using debt fund
Financial proposers say that an investor should not invest a large amount in securities at once. In its place, SIPs are the best method to purchase equity funds. If you have lots of money to invest, you can invest that money in a debt fund and begin a systematic transfer plan to the equity funds you want. Each month, a fixed amount will be transferred from the debt fund into the equity funds you have chosen.
Bear in mind the exit load on debt funds
A debt fund is a very liquid scheme. You can pull out your investments at any time you want and the money will be transferred to your bank account in just a day.
On the other hand, some debt funds charge a fine for withdrawing before the minimum period of holding the investment is over. That fine is called as the exit load. The exit load can differ from 0.5% to 2%, and the minimum period of keeping the funds can vary from six months to two years.
Before making any kind of investment, it is better to check the exit load of the debt fund you are planning to invest in. Even as little as 1% exit load can cut off a substantial slice from your gains.
What Makes Debt Funds A Better Option As Compared To The Fixed Deposits?
Debt funds are a type of mutual funds which invest in diverse types of fixed-income securities. For instance, Corporate Bonds, Government Bonds, Money Market instruments, Treasury bills and many other similar instruments. They are quite appropriate for the purpose of short-term investments since they are not as capricious as mutual funds with equity shares.
In India, fixed deposits have conventionally been the favored debt instrument. Nevertheless, debt mutual funds have a lot more to offer as compared to the fixed deposit. Given below are a few reasons why debt funds are better than fixed deposits:
When you invest in a fixed deposit for a certain period of time you cannot convert it back to the money before the time period of the said deposit is completed.
If you break your fixed deposit before that you will have to pay a penalty on the complete amount even if you need only a portion of it.
On the other hand, debt mutual funds are rather liquid. You can convert them into money – whatever amount you want, whenever you want, and wherever you want.
There might be some exit load with the debt fund when leaving before the minimum time. Nevertheless, they will be applicable only on the amount you withdraw and the remaining amount will stay invested.
In fixed deposits, the banks take away TDS in case the interest is over 10,000 Rs. in a year. If your PAN is joined with your bank account, the TDS will be 10%. In addition, if your PAN is not connected with your bank account, TDS will be 20%. In debt funds, no taxes are needed to be paid until they are converted into the money in the market. Hence, you can comply tax payment in debt funds until the period you retain them.
The fixed deposit tax rate is very much similar to the tax bracket and it is same for the debt funds that are cashed before 3 years. On the other hand, for the debt funds that are held for over 3 years the tax rate would be 20% with indexation advantage and therefore it comes out to be much lesser.
Fixed deposit returns are usually offered in the range of 5% to 7.25% only. Moreover, in the past years, FD rates have reached a maximum of 9.25% only and that was also just for a year. After that, it started coming down to its current level bit by bit.
However, the returns of the debt funds have proven to be much better with several funds providing greater returns, for example, 3-year return on Intermediate Government Bond Category has been 10.08%, as on 30th Aug 2017.
Debt funds offer a great level of steadiness and they are highly recommended by the market experts so as to make them a part of every investment portfolio as they are highly effective in bringing down the instability. It would be wise to keep growing the percentage of the debt in your portfolio as your investment horizon arrives.
For instance, you plan to hold a portfolio for 10 years i.e. your investment horizon is 10 years. You start with a ratio of equity and debt say 80:20.
However as the years go by and you reach close to the completion of your investment horizon, like 5 years are left, it would be a practical choice to increase the debt portion to about 50%-60%. As you reach closer to your 10-year period, you can increase the debt percentage up to 80%-90%, and when only 1 or 2 years are left in reaching your investment horizon, you can make it to 100%.
Systematic Investments Plans
Whereas the fixed deposits are only one-time investments, you can use debt funds to invest systematically in order to fulfill your longstanding objectives. You can carry on your investment plan over many months by putting in a small sum each month. By using systematic investment plans, you can increase your wealth steadily.
Hence, this is how debt funds have proven to be a better choice than fixed deposits. If you are a new investor and just trying to test the waters, you can even ponder over choosing equity mutual funds instead of fixed deposits. Equity comes under an asset category that can help you in building wealth. In addition, long-term returns on equity funds are also exempted from tax.
As a result, your next question could be whether you should invest in fixed deposits or not. The answer is no that is not the case. Fixed deposit and debt funds, both are the good investment opportunity. It is just that one option offers you a little more than the other.
Fixed deposits do have something to offer, especially when you are investing your money for a definite purpose or a non-negotiable objective or when you under no circumstances can afford to take even the smallest amount of risk, you can always go for fixed deposits. They are also a great choice to store money for emergency times that you can have access to, that is by using overdraft services.
Other than that, investing in debt funds makes a lot more sense as compared to the fixed deposits. Even more so, if you want to invest for a long-term purpose. Debt mutual funds can help you arrive at your goals and objectives in a much quicker way.
With your standard percentage of debt in your portfolio, which will continue for more than 3 years, debt funds are a lot better choice owing to their dependable long-term performance record, tax proficiency and benefits, and flexibility to transfer.
However, in the end do not invest in debt funds, until you have done all the research and collected the required information. Do your homework thoroughly and completely.
Consider factors like performance record, characteristics of specific schemes, credit quality or creditworthiness of the portfolio, past performance of the fund manager, and expense percentages. These are a few factors to consider, there are many more decisions to make before you take your final investment decision.