Debt Mutual Funds versus Bank Fixed Deposit

Whether to invest surplus money in debt mutual funds or in traditional bank FDs? This is one of the most perplexing questions for investors who are looking to park their money in debt instruments. Even though the mutual fund industry has grown leaps and bounds in the last few years, the growth is primarily in the inequity schemes and when it comes to debt investments Bank FDs still remains the favorite investment option for the common man. Safety of capital and guaranteed returns are the two reasons for people to invest in Bank FDs.

However, the banks have cut the interest rates dramatically, almost 2.5% in the last 3 years, the returns on Bank FDs are much lower today and if you look at the inflation-adjusted post-tax return is negligible. Debt funds, on the other hand, have performed better as compared to Bank FDs. Debt funds, though a category mutual funds, invest in fixed income earning instruments, such government bonds, money market instruments, RBI bonds, and corporate deposits etc. which are professionally managed and carry very little risk.

Let us look at some of the important parameters to understand which better investment option and why.

Return on Investment

Bank FD offer a fixed rate of return for a fixed tenure and at the end of the tenure, you will receive your entire capital along with the fixed interest rate. The current rate of interest on Bank FD is roughly between 6.5% before tax and the post-tax return is dependent on your income tax slab. If you are in the 30% bracket then the effective return on your Bank FD is 4.55%.

In case of debt mutual funds, there is no fixed return guaranteed and the returns are dependent on the performance of the scheme. But if we look at the historical performance of debt funds, the returns generated by such funds are 7.5% to 9% which is much higher than the return on a Bank FD. If the investment is for more than 3 years then you stand to gain from the benefit of long-term capital gains tax.

Liquidity

Liquidity is low in Bank FDs. Though most banks allow pre-mature withdrawal with a penalty charge of 1% to 1.5% and interest rates will vary depending on the amount of time the investment was held with the bank. Partial withdrawal is also not allowed in case of Bank FD.

In case of debt funds, an investor can withdraw the entire amount after completion of one year. Partial withdrawal is also possible. If the investment is held for less than a year, then an exit load of 0.5% is levied. Thus in terms of liquidity, debt funds are more flexible when compared to a bank FD.

Taxation

Debt funds have an edge over FDs when it comes to taxation. Interest income of a Bank FD is added to the income of the individual and taxed as per the applicable tax slab, irrespective of the tenure, thus making them extremely tax inefficient.

Tax on debt funds is calculated as short-term capital gains and long-term capital gains depending upon the tenure of the investment.  If the investment is held for more than one year but less than three years, then the tax treatment is same as that of a Bank FD, but if the investment is made for more than 3 years, then the investment qualifies as long-term capital gains and is taxed at a flat rate of 20% with indexation benefit, thus making them more tax efficient than a bank FD. The dividend income received in case of a debt fund is also exempt from tax.  Thus, if you are looking at investing for more than 3 years debt fund is definitely a better option.

Though debt funds do not offer fixed returns, if you are open to taking a little risk for better returns and capital appreciation of your investment, it is better to invest in debt funds as not only for better returns, but also for the fact that they  provide  liquidity and are more tax-efficient than a traditional Bank FD.