Fixed Deposit versus Debt Mutual Fund

If you have a sizeable amount of money saved up and your primary investment goals are:

• To invest in a low risk, non-volatile, and safe avenue.
• To see returns within 5 years.
• To see at least an 8% - 9% rate of returns.

Then you have two widely popular investment options open to you – Fixed Deposits (FDs) and Debt Mutual Funds (Debt Mfs). These are both investments that meet the above criteria, and have their own features which distinguish themselves from each other. The differences in the way these two investments work can be seen as advantages or disadvantages depending on the type of investor you are.

Which is the better investment option? Fixed deposit or debt mutual fund?

To answer this question, one must consider the following points, and evaluate the type of investor he or she is:

1. Safety of Capital invested.

• Fixed deposits:
• Have a credit rating system (as shown in the table below) that classifies and segregates investments based on overall safety of the initial capital invested.
• The classification and rating system takes into account various factors like commodities and securities or avenues being invested in, the duration, the current market status, its volatility, etc. and gives you a real picture of how your investment can be expected to perform and how safe your investment is.
• Are guaranteed by the government up to the extent of Rs.1,00,000.

Rating	Typically issued by:	Safety Level
"Sovereign"	The Government of India.	Highest – no investment is safer than a "sovereign" investment.
"AAA"	Banks, large private companies and PSUs.	Very high – there is little likelihood that your investment will do badly.
"AA"	Private companies.	High – these are tried and tested investments and consistently perform well.
"BBB"	Private companies.	Below average – you stand a very realistic chance of losing your capital.
"BB", "B", "C" and lower	Private companies.	Poor – you will almost definitely lose your invested capital and have probably fallen victim to empty promises of huge returns.

• Debt Mutual Funds:
• Do not have a rating system, but the safety of the investment is gauged on the investment portfolio. Approximate investment safety levels are considered.
• Involve a lot of diligent analysis simply to determine the safety of the investment.
• Are not guaranteed by any authority to any extent.

If you’re the kind of investor who has a high risk appetite and can afford to wager your savings – for a potentially huge benefit – but against staggering odds in an unstable financial market that’s littered with scams, then try your hand at debt mutual funds. You might get lucky.

If you’re the kind of investor who falls in the majority category of those who wish to take a highly informed decision to invest hard earned capital in an established avenue of investment, which has a safety rating and is guaranteed up to Rs.1,00,000 – invest in fixed deposits.

2. Premature withdrawal from investment.

• Fixed Deposits:
• Do not allow withdrawals before maturity. If a withdrawal is necessary, you will have to break your FD.
• Few banks allow for partial withdrawal (or partial breaking), but in most cases the FD will have to be entirely broken.
• Breaking a fixed deposit results in lower rate of interest and payment of penalty.
• Penalties range from 0-15% of the initial invested amount.
• Debit Mutual Funds:
• Any amount can be withdrawn from the debit mutual fund account.
• Amounts can be withdrawn at any time, and the mutual fund continues to function on the remaining amount.
• There is no loss of interest rate.
• Penalties are charged in the form of exit load, ranging from 0.25% - 1% and only applicable for periods less than one year.

If you feel that you will need to break your investment before it reaches maturity and liquefy funds at short notice, then invest in debt mutual funds. But bear in mind that you will never receive the full benefit from any form of investment if you habitually break investments.

If your investment pattern involves allowing all your well-planned and premeditated investments to fully reach maturity – and make full use of the huge maturity benefits – then invest in fixed deposits. Once an investment has been made, it is assumed that enough precautions and measures have been taken to allow for full returns.

Keep in mind that any investment, if withdrawn halfway through, will never pay out as much as you had hoped.

3. Rates of Returns on Investment.

• Fixed Deposits:
• Operate on the model of a fixed interest rate that’s communicated before you invest.
• Current interest rates are around 8% - 9% (for investments > 1 year). This does not change due even in financial crises or volatility.
• Enables financial planning.
• Guaranteed return on investment.
• Allows for calculation of an accurate amount of money that can be expected as total return on investment.
• Debt Mutual Funds:
• No fixed pre-communicated rate of interest.
• Rate of interest must be guesses at based on previous fund performance and investment portfolio.
• No guaranteed returns on investment.
• Rate of returns are subject to market volatility and fluctuations in interest rates.

If you are the type of investor who no desire to know what the end result of the investment will be, or wishes to take the chance at perhaps earning more due to fluctuations in the market which could raise the rate of returns – then invest in debt mutual funds. These funds do not earn interest, but earn dividends which could go higher or lower than you anticipate. Historical performance data, however, does not support the notion that returns will be high.

If your idea of investment is to have full knowledge and awareness of exactly how much you’re investing, and how much you expect to receive as profitable returns, then invest in fixed deposits. These will give you a real picture of what to expect, and when to expect it. It also facilitates better financial planning, as you will already know how much the maturity amount is and how much you’ll be earning at the end of the term.

4. Tax Liability.

To understand the different taxes that apply on these investments, it’s important to understand the kind of return on investment they offer. Fixed deposits offer you return on investment in the form of interest, and Debt Mutual Funds offer return on investment in the form of capital appreciation or dividend. These two heads of income are taxed differently.

• Fixed Deposits:
• Attract a high rate of tax. Up to 30% depending on your personal tax rate.
• Tax is applicable even on accrued interest which hasn’t been received yet.
• Eventual income that compounds is lesser than in the case of non-taxed dividend income.
• Debt Mutual Funds:
• Attract the same rate of tax as FDs during the first year.
• Taxed at a lower rate than FDs between the first year and third year.
• Tax free from third year onwards.

The reason that capital gains and dividend are taxed at a lower rate than interest income is because it is unsecured and a certain element of risk exists – bringing with it ambiguity about whether the investment will yield a profit or not. This risk is balanced by lower taxation, but leaves the investor open to the possibility of losing his investment. Interest income is taxed because it is a definite source of income which has been promised to the investor and has been secured up to Rs.1,00,000. A little taxation is a small price to pay for an investment that will almost certainly yield a profit and returns.

If your investment strategy aims at saving on a little tax at the cost of exposing yourself to risk, invest in debt mutual funds.

If your investment strategy aims at secured and guaranteed returns on investment from a high rated scheme, invest in fixed deposits.

Overall, it should be noted that fixed deposits are the investment of choice for the majority of people who have investable amounts of savings, as it is a safer and more secure investment where funds are locked until they mature. It is ideal for those looking to park their funds and earn a decent amount of interest and benefits. Economic fluctuations do not affect the rate at which interest will accrue, as it is decided beforehand.

Debt mutual funds, on the other hand, are investments which are less secure and can fail due to multiple reasons not limited to fluctuations in the economy. These investments are for those who can afford the risk in order to enjoy the slightly higher reward (when compared to fixed deposits). The primary advantages here are that you can liquefy your investment fast and at minimal cost, and can save on tax – at the cost of a risky investment platform.