Let us start with basics. This article will mostly revolve around three things i.e, SIP, Debt Mutual Funds, and Bank Recurring Deposits.
And this why it is imperative for us to get an understanding of them.
When it comes to systematic investment planning in mutual funds of any kind many of us have a basic idea about its way of operation, advantages, and disadvantages associated with it. But still, some get confused as to what exactly it is and how it works.
Systematic Investment Plan (SIP)
So a systematic investment planning allows you as an investor to invest a fixed amount regularly in mutual fund schemes which are mostly related to equity.
Now what it does to you is it helps you in different ways which we will soon discuss and compare with the benefits associated with the bank recurring deposits.
Recurring Deposits (RD)
Recurring deposits are term deposits where people with a regular income can deposit a fixed amount every month for a particular period of time and on maturity get the principal plus the interest.
Although both of them seem similar, there are a lot of differences between the two which we will unfold later.
Debt Mutual Funds
The third item in our list is the debt mutual funds.
The sole purpose of this article is to talk about the reasons why a SIP in debt funds are better than bank recurring deposit and to do this we need to understand what exactly debt mutual funds are.
Debt mutual funds are mutual funds that invest mainly in a combination of debt or fixed income securities such as, Government Securities, Treasury Bills, Money Market instruments, Corporate Bonds and other debt securities of different time periods as per the convenience of the investor.
SIP in Debt Funds Over Bank Recurring Deposits
SIP in debt funds can provide an investor with a return of around 7-8% on an average.
Whereas a bank recurring deposit would provide a return of 5-7% to the investor.
Considering that the risk factor of both the type of investment is similar, a higher return provided by debt funds is more preferable than the investment in bank recurring deposits.
Although most SIPs require investing a fixed amount every month, the additional feature that comes with SIP’s is that one can customize it according to their requirements.
You can easily start SIP for additional amounts or cancel an existing SIP and start a new SIP with a newer amount.
This is not possible in case of recurring deposits where only a fixed amount is invested every month and the interest is paid along with the principal at maturity.
Also if any of the installment is delayed, there will be a reduction in the interest payable in the account and that will not be enough or sufficient to reach the maturity value.
Therefore, there will be a penalty and the difference in interest from the maturity value will be deducted. The rate of penalty is fixed.
So if you are looking for customization, SIP in debt funds are a better option than bank recurring deposits.
#3: Rupee Cost Averaging
Another feature of the SIPs is that they help the investors to average their purchase cost and maximize returns accordingly.
When the investors invest regularly over a period of time irrespective of the conditions the market is in, what happens is they get more units when the market conditions are not good and fewer units when the market is booming.
In the process what happens is that the purchase cost of your mutual fund units is averaged out.
SIP in debt funds will provide you with the option of more liquidity as compared to bank recurring deposits.
As discussed earlier recurring deposit is liquid but premature withdrawal would incur a penalty with a fixed rate.
Money can be withdrawn from SIP in debt funds without incurring a penalty on it and the SIP can be closed.
In terms of liquidity, a SIP in debt funds is a better option when compared to RD.
#5: Lower Taxes
Up to 3 years, the taxation on debt funds and RD is similar.
However, after 3 years from investment, the tax on debt funds is significantly lower than the tax on RD.
After 3 years from investment, the tax on debt funds is 10% without indexation plus 3% less.
At the same time, RD keeps attracting the same rate as before 3 years from the investment – which depends on your income tax bracket.
#6: Section 80C Deduction
Another important feature of investing in SIP in debt funds is that capital gains from the investment can be exempted from tax if the debt fund in which the money is invested in is an ELSS (Equity Linked Saving Scheme) fund.
Although there is a lock-in period of 3 years in this case.
Whereas recurring deposit amount or the interest earned from it are not exempted from tax. This is another advantage of investing in SIP in debt funds over bank recurring deposit.
Another benefit of SIP in debt funds is also known as the eighth wonder of the world that is the power of compounding.
Investing over a long period in a SIP can make the investor earn returns on the returns earned by the investment and before they realize the invested money starts compounding.
This enables the investors to build a large corpus that will be sufficient to achieve their long-term financial goals with small but regular investments.
Although interest is also compounded on the quarterly basis in the recurring deposit, it cannot be matched with SIP in debt funds simply because the returns offered by debt funds are much higher – so over time, the difference in returns is greater too.
Understanding Debt Funds in Greater Detail
In general, debt securities come with a fixed maturity date & pay a fixed rate of interest.
Credit ratings are also assigned to debt securities.
These credit ratings help the investors to understand the ability of the issuer of the securities or bonds to repay their debt, over a certain time horizon.
There are different rating organizations such as CRISIL, CARE, FITCH, Brickwork, and ICRA that are responsible for issuing the rating to the securities.
Fund houses use the ratings to evaluate the ability of the issuer of the security to repay their debts or the creditworthiness of issuers of debt securities.
So a simpler way to understand debt funds will be to consider them as a way of passing through the interest income that they receive from the bonds they invest in.
But that is not as simple as it looks and there are still some complexities involved it.
Debt Mutual Funds, unlike the FDs that individuals invest in, makes investments in bonds or securities that are tradable, just like shares in stock markets are tradable.
And similarly to stock markets, the prices of different bonds on the debt markets can rise or fall according to the market conditions prevailing at the time.
Read: 10 Debt Funds That Gave Better Returns Than FD
And according to the market conditions the mutual fund house can decide to buy a bond or sell it and if its price subsequently rises, then they can make money over and above what the fund house or the investor could have made out of the interest income.
This, in turn, will result in a higher return for investors. But a question would have popped into your mind as to why would bond prices rise or fall?
What makes them volatile just like the share prices of the company?
So there can be a lot of reasons behind it. But the most important one is change in interest rates.
Not even the actual change but the expectation of such a change could result in rising or falling in bonds or security prices in the debt market.
Let us suppose that there is a bond that currently pays out interest at a rate of 9% per annum.
Now due to changing market conditions, the interest rates of the economy falls and newer bonds that are issued pay out interest at 8%.
This makes the first bond worth more than earlier as the given amount of money invested in it can earn more money due to higher interest payment and subsequently its price would now rise.
Mutual fund houses that keep holding this bond would find their holdings worth more and this would enable them to make additional profits by selling this bond.
Having seen all the advantages that investment in SIP has over bank recurring deposits it becomes clear on what to choose when you are confused on what to invest in do make sure to do a thorough analysis before investing in any scheme.
Disclaimer: the views expressed here are of the author and do not reflect those of Groww.