Fixed Deposit Or Mutual Fund. How To Choose?

Fixed deposits are the most common type of investment for most Indian households. According to RBI research released in June 2020, bank FDs account for 53% of average household financial assets (as of March 2020). Though mutual funds have a long history in India, with the establishment of the Unit Trust of India in 1963, their popularity among retail investors has only grown in the last 20 – 25 years. According to AMFI data, the AUM of mutual funds in India has grown at a CAGR of nearly 17% over the last 20 years. Despite their rapid growth, according to RBI data, mutual funds account for only 7% of household savings. We will contrast FDs and mutual funds so that investors can make an informed decision about whether to invest in FDs or mutual funds.

What exactly are Fixed Deposits?

FDs, as the name implies, provide investors with a fixed interest rate for a set period of time. The duration of an FD can range from 7 days to 10 years. Bank FD interest is compounded, which means you get interest on interest that has already accrued. The declining interest rates are a source of concern, particularly for senior citizens who invest their savings primarily in FDs. Over the last 25 years, FD interest rates have been steadily declining. With the RBI aggressively cutting interest rates in the aftermath of the COVID-19 outbreak, banks have also reduced FD interest rates. Post-tax, FD interest rates can no longer even keep up with inflation. FD interest is taxed based on the depositor’s income tax bracket. Because the FD interest rate is fixed over the FD tenure, there is no indexation benefit in taxation when comparing FD vs mutual fund. As a result, there is no protection against inflation, especially since FD interest rates are so low.

The Most Important Facts About Fixed Deposits

1. The principal deposited in fixed deposits remains unchanged. It does not gain value or grow in any other way.
2. If the RBI decides to change the interest rate, the interest rate offered by the bank may change.
3. You know exactly what your fixed deposit return is with fixed deposits. It is a highly predictable financial instrument.

What exactly are mutual funds?

Mutual funds are financial instruments that are created by pooling money from many investors and are managed by Asset Management Companies. Mutual funds are portfolios of stocks or bonds in which unitholders own a portion of the stock or bond. Mutual funds provide a variety of investment options based on the financial needs of investors. Equity mutual funds primarily invest in the stock market, whereas debt funds primarily invest in the money and bond markets. The primary investment goal of equity funds is capital appreciation, while the goal of debt funds is to generate income.

When investing, select schemes whose fund managers have a strong track record of long-term performance. The table below shows the annualized returns of the top-performing equity and debt mutual funds over three, five, and ten years.

One significant advantage of mutual funds over fixed deposits is taxation. Mutual funds are one of the most tax-efficient investments available. Short-term capital gains in equity funds (held for less than 12 months) are taxed at 15%, while long-term capital gains (held for more than 12 months) are tax-free up to Rs 1 lakh and taxed at 10% thereafter.

The Most Important Facts About Mutual Funds

1. The initial investment in mutual funds has the potential to grow in value. Because mutual fund investments are linked to the capital market, if you stay invested in one for a long time, your money has the potential to earn higher returns.
2. The longer the duration of your investment, the greater the possibility of higher returns.
3. Mutual fund returns, unlike fixed-income investments, are not predictable and are subject to a variety of market risks. You can make an educated guess as to how much you can earn, but you may not know with certainty.

Mutual Funds vs FD: Key Financial Parameters

Returns

• The performance of the stock market has a direct impact on mutual fund returns. If the stock market continues to perform well, mutual funds will provide appropriate returns. In terms of return profile, fixed income mutual funds are more similar to fixed deposits. Long-term mutual fund returns have been around 12% on average over the last 5-6 years, while mid and short-term mutual fund returns (debt funds) have been in the range of 6%-7%.
• The returns on fixed deposits are predetermined. Fixed deposit returns are payments that are guaranteed for the duration of your investment. The average rate of return on fixed deposits has been in the 6 % to 8 % range. The interest rate on a fixed deposit is determined by the bank with which you open an account.

Risk

• There’s a reason why the phrase “mutual fund investments are subject to market risks” is frequently heard in the market. This is due to the fact that the risk of equity mutual funds is linked to market risk. Mutual fund risk is also affected by the type of fund in which one invests.
• The risk of a fixed deposit is relatively low. The fixed interest payment will continue to be made to the depositor. This is due to the fact that fixed deposits are unaffected by market movements. However, a bank can still fail, and your FDs are only insured up to Rs 1 lakh.

Growth

• As previously stated, equity mutual fund growth is linked to market growth and is determined by how the mutual fund performs over time. If the market is rising, your principal investment will continue to grow.
• The principal amount deposited in a fixed deposit remains constant throughout the investment term.

Withdrawal

• Withdrawing from a mutual fund is a simple process. If you’ve invested in an open-ended fund, you can take your money out at any time. Some mutual funds may require you to invest for a minimum of one year. In some cases, you may be required to pay a 1% exit load fee.
• Fixed deposit withdrawals, on the other hand, are subject to a penalty fee. If you choose to withdraw your deposit before your deposit tenure is up, you will be charged a penalty fee.

Impact on inflation

• Mutual funds are one of the best ways to beat inflation for most investors. Stock funds can provide you with higher long-term returns because they tend to outperform inflation.
• The returns on FDs may not be sufficient to offset inflation. Inflation depletes your savings. In the case of high inflation, you would receive a negative return. Furthermore, the interest rate on an FD is set at the time the deposit is opened and does not change. However, mutual funds can provide inflation-adjusted returns.

Taxation

• Mutual fund taxation is a little difficult to grasp. Almost all mutual funds are subject to capital gains, both short-term and long-term. Short-term capital gains tax (STCG) is levied at a flat rate of 15%, whereas long-term capital gains tax (LTCG) is levied at 10% of earnings above Rs 1 lakh in the case of equity. LTCG is charged at 20% after indexation in the case of debt mutual funds. If you’d like to learn more about how mutual funds are taxed, click here.
• Fixed deposits are taxed in accordance with the depositor’s income tax bracket. Fixed deposits are subject to a 10% TDS on interest earned in excess of Rs. 10,000 in a fiscal year.

Though FDs are said to be risk-free investments, investors should be aware that the liquidity and safety of FDs are dependent on the bank/financial institution’s financial solvency. Banks are regulated by the RBI, which strives to ensure prudential lending standards in order to keep depositors’ money safe. However, several instances of violations of RBI norms have recently occurred, leaving depositors in the lurch. Depending on the circumstances, such incidents may result in withdrawal suspension, withdrawal limits, or even the inability to withdraw funds indefinitely.

Note: As per current DICGC rules, each depositor in a bank is insured up to Rs 1 lakh for both the principal and interest amount on deposits held by him in that particular bank. This includes all deposits held by a person in the current account, savings account, fixed deposits, and so on. If the total of all the deposits held by an individual in a single bank exceeds Rs 1 lakh, then he/she will be able to get only Rs 1 lakh inclusive of principal and interest amount if the bank goes bankrupt.

Conclusion

In this article, we discussed the differences between FDs and mutual funds. FDs provide guaranteed returns, whereas mutual funds are subject to market risks. Mutual funds, on the other hand, can be good investment options in a declining interest rate environment if you understand your risk tolerance and invest accordingly. Mutual funds have a significant tax advantage over FDs due to indexation benefits in long-term capital gains taxation of debt funds. To make informed investment decisions, you should assess your financial goals and risk tolerance.