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Why Debt Mutual Funds are Better than Fixed Deposits

Fixed deposits (FD) are not just investments, they are a part of Indian tradition and culture. Our grandparents and parents have sworn by FDs for most of their lives. Whenever they received a bonus, they invested it in an FD. Whenever they had to save money for a goal, they put it aside in an FD. FDs were their go-to investment product and for good reason too.

A large number of Indians invest in fixed deposits because they offer guaranteed interest as well as capital protection. This means that your hard-earned money is not going anywhere. Your money is going to be safe and you will earn a fixed interest on it as well. Both of these are reasons that have been good enough for the earlier generations to invest in FDs. But do they make as much sense even now?

The world has changed in many ways over the past couple of decades. Lifestyles have changed, dreams and aspirations have changed and even how the economy functions has changed. Fixed deposits may not be enough anymore, especially for those who have joined the workforce in the past few years and have begun investing recently. For young investors, mutual funds would be a better option than fixed deposits. Let’s dig deeper to understand why.

Fixed deposits versus debt mutual funds

Fixed deposit investors may not want to move directly to equity mutual funds, but debt mutual fundsare investment options that they should definitely consider. The first reason to move from FDs to debt funds is higher returns.

Sure, fixed deposits offer guaranteed interest. But do you know that the interest earned is taxed at the income tax slab that you fall under? Income tax eats into the interest you earn from FDs.

As you can see from the table, the higher your tax bracket, the more you end up paying in tax from the interest you earn from FDs. In comparison, debt mutual funds are more tax efficient. Short-term returns from debt funds are taxed as per your tax slab. But long-term returns are taxed at 20% after indexation, which can come down to effectively 6-7%. So, if you hold a debt mutual fund for 3 years or more, you have to pay only 6-7% tax on it, irrespective of the income tax slab you fall under. This can greatly enhance your returns.

Even if we don’t take tax under consideration, the returns generated by debt mutual funds are higher than those by fixed deposits.

Annualised returns as on 9 June 2017

The interest earned from a fixed deposit is guaranteed, but the returns from a debt funds are not. However, debt funds are considerably safe investments. The returns that they earn are worth the risk they come with. After all, it is only through mutual funds that you will be able to beat inflation. The post-tax interest rate of fixed deposits will not be enough to allow your invested money to grow beyond the prevailing rate of inflation.

Apart from the higher returns that they can earn, debt mutual funds also have the following advantages over fixed deposits:

Liquidity: 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.

Flexibility: Once you have invested in an FD, you can’t move the invested amount to another bank that is giving you more interest. This kind of flexibility is available with debt funds. You can move from one fund to another if the fund you have invested in is underperforming.

Systematic investments: While FDs are one-time investments, debt mutual funds can be used to invest systematically for long-term goals. You can spread your investments over several months by investing a small amount every month. This systematic investment method allows you to build wealth gradually.

This is how debt mutual funds trump fixed deposits. Young investors, who have a long earning life ahead of them, can even consider equity mutual funds over fixed deposits. Equity is an asset class that can help create wealth. Plus, long-term returns from equity funds also become tax-free.

So, does all of this mean you should not invest in FDs at all? No, that’s not the case. Fixed deposits do have a case when you are investing for a specific purpose or a non-negotiable goal. When you cannot afford to take even the slightest risk, you should opt for fixed deposits. They are also ideal to park emergency money that can be accessed by availing overdraft facilities.

Apart from these cases, mutual funds make sense over fixed deposits. More so when you are investing for the long-term. Mutual funds will help you reach your goals and targets quicker.