Debt fund vs Fixed deposits

We have heard a lot from our parents about Fixed deposits as the investment product. Every month our father will save some money and make a fixed deposit and continue renewing it. This is being considered as the safest investment tool by them. May be this is the only investment tool known to them especially in small towns. Things have changed a lot since their time and we have many new investment products. There are mutual funds to invest and debt mutual funds are best alternative for fixed deposits, which carry less risk when compared to equity mutual funds. There are different types of debt funds to cater short term and long term needs.

Here i will discuss some of the features which distinguish fixed deposits and debt funds.

Safety of capital invested

Bank deposits are one of the safest investment modes in India with almost no chance of getting default (although there have been cases of some local banks and co-operative banks getting default). With the debt mutual funds there are no guarantees and returns are market linked. All above said is good in theory.

The mutual fund industry is regulated by SEBI, different types of funds have different risk profile. In practice, liquid funds and ultra short term funds are as safe as fixed deposits and can be used as best alternative for short term fixed deposits. Short term debt funds can be used to replace long term fixed deposits.
    

Returns on investment

As far as the returns are considered, debt funds beat the fixed deposits. Returns from debt funds are far better than FDs and with the current falling rate scenario it's wise to invest in debt funds for higher and safer returns. Let's have a look at the returns given by various debt funds and fixed deposits as of today's date.

	Category Average Returns
	Debt Fund Category	Liquid Fund	Short Term Funds	Income Funds	Dynamic Funds	Fixed Deposits
	One Year Returns (%)	7	9	10.5	11	6.5
	Three Year Returns (%)	7.9	9.75	11.1	11.5	6.5
	Five Year Returns (%)	8.4	9.5	9.8	10.1	6.5
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From the above table it is evident where to park your money. Returns above are actual returns. If we consider inflation and tax liability than picture will be different and you fill find later in this post that fixed deposits are giving you minuscule or negative returns.

Liquidity and Pre mature withdrawal

Fixed deposits have a lock-in period. You have to stay invested in them for the prescribed tenure or risk losing the interest earned on them. Unlike them, debt funds are completely liquid. You can withdraw your full invested amount plus returns earned or a part of the total value any time you want.

	Liquidity: Debt fund vs Fixed Deposit
	Parameter	Debt Fund	Fixed Deposits
	Maturity	There is no maturity period of debt funds and amount can be withdrawn as per need.	Amount from fixed deposits can not be withdrawn before maturity, in case you need money you need to break your FD and have to pay penalty for that.
	Partial Withdrawal	No need to withdraw whole amount. You can withdraw the amount needed and rest of amount will keep earning interest.	There is nothing like partial withdrawal and whole FD needs to be broken.
	Penalties	Penalties are charged in the form of exit load, ranging from 0.25% - 1%  and only applicable for periods less than one year (at max). Liquid funds don't have any exit load	Banks lower your interest and charge penalty for breaking FD.
	Withdrawal time	Liquid funds have instant redemption facility while other funds may take 1-3 working days.	Fixed Deposits may take 1-2 days.
	Loss of interest	There is no loss of interest. The amount which is not withdrawn from fund continue to earn same interest like nothing has happened.	Since whole FD needs to broken, whole amount losses interest even if you need only partial amount.
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Taxation 

One big difference is the tax liability on funds and fixed deposits.

• Fixed Deposits
    
• Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 per cent) tax bracket, this takes away a large chunk of their returns.
    
• Banks deduct TDS even on accrued interest which hasn’t been received yet.
     
• Debt Funds
    
• The tax rates are similar to fixed deposits for the debt funds held for less than 36 months but no TDS is deducted.
     
• Debt funds held longer than 36 months, returns are classified as long term capital gains and are taxed at 20 per cent (irrespective of tax slab) with indexation.
       
• Tax is applicable only when you redeem debt funds. There is no tax liability on the interest earned if units are not redeemed.

Lets compare the real returns from fixed deposits and debt funds.

	Taxation: Debt funds vs Liquid Funds
	ROI assumed for Fixed deposits is 7%, Debt funds is 9% and Inflation as 6%
	Tax Slab	Fixed Deposits	Debt Fund less than 3 yrs	Debt Fund more than 3 yrs	Real Returns from FD
	5 %	6.65	8.55	No tax, only LTCG is applicable when redeemed	(+) 0.65%
	20 %	5.6	7.2	No tax, only LTCG is applicable when redeemed	(-) 0.4%
	30 %	4.9	6.3	No tax, only LTCG is applicable when redeemed	(-) 1.1%
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As we can see in the above table that the real return after considering inflation is very less and even negative. It hurts maximum to those who are in highest tax bracket of 30%. For more details on the taxation on debt funds, you can read this post.

I have covered all the differences between fixed deposits and debt funds, now is the time to understand this with a real example.

Example

Calculation is done over a period of 10 years and income tax rate is assumed to be 30%.
  

 

In the above example, consider that the amount left in the fund is not withdrawn till retirement, then till that time it will continue to grow and you don't have to pay any tax till that time but with fixed deposits you need to pay tax even if there is no withdrawal. 

In summary, you can beat the bank by investing in debt funds instead. However you should be cognizant of the risks involved and choose the right fund in order get the best possible deal.

Happy Investing!!!