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Session 21: Mutual Funds vs Fixed Deposits

We are glad to have you with us for our Twenty First Session - Mutual Funds vs. Fixed Deposits

So let us now begin with our learning session today.

Many of you may be quite familiar with this traditional investment instrument that is considered safe and caters to the needs of a large category of investors in India, even today. Being a financial instrument provided by banks in India, it offers returns better than the regular savings account and hence enjoys an edge when it comes to earning better returns on one's savings. Yes, we are talking about 'Fixed Deposits'.

It usually ends up in a long debate when it comes to comparing fixed deposits with other investment avenues like mutual funds. In our learning session today, we'll try to present a clear and unbiased comparison which may help you choose a suitable investment avenue (i.e. Mutual Funds or Fixed Deposits) to meet your financial goals.

So, let us see which of these are more advantageous - mutual funds or fixed deposits. But first, let us take a look at what are...

Fixed Deposits

  • (Fixed Deposits are...) A Traditional Financial Instrument offered by Banks

  • Fixed Deposits Provide Rate of Interest Higher than Regular Savings Account (...Banks compensate you for committing your money with them for a longer time period)

  • (They...) Offer Fixed Rate of Interest for a pre-specified Tenure (...So you will continue to enjoy the same interest rate throughout the tenure. Such interest rates may vary from bank to bank, ranging from 4% to 10% or sometimes even higher. Generally, the longer the term of deposit, the higher would be the rate of interest offered by the bank)

  • Fixed Deposits come with a pre-defined Maturity Period (...You can fix your money at a higher rate, right from 7 days to as long as 10 years)

  • (But there is a restriction on withdrawal of the money before maturity...) Banks may Charge a Penalty for Premature Withdrawal (...Say, you invested in a FD offering interest @ 9% p.a. for 5 years; but due to some emergency you need to withdraw the money after 3 years. In this case, the bank will pay you interest applicable for 3 years of your investment tenure, leaving you with a lower interest rate of, say, 7%. So you would lose 2% on returns and maybe an additional 1% in the form of penalty for premature withdrawal)

  • Fixed Deposits are considered to be Safe Investments ( they are covered by the Deposit Insurance and Credit Guarantee Corporation (DICGC). However, DICGC guarantees an amount of up to Rs 1,00,000 per depositor per bank - for both principal and interest. It is noteworthy that deposits kept in different branches of a bank are aggregated for the purpose of insurance cover and a maximum amount of up to rupees one lakh is paid to the depositor.)

  • (Apart from Fixed Deposits...) Banks ( India...) also offer Recurring Deposits and Flexi Fixed Deposits ( investors)

While in our past sessions we told you all about investing in mutual funds and how it is beneficial for you. Here we have compared mutual funds and fixed deposits on various parameters.

Mutual Funds vs. Fixed Deposits

Parameters Mutual Funds Fixed Deposits
Rate of Returns No Assured Returns Fixed Returns
Inflation Adjusted Returns Potential for High Inflation-adjusted Returns Usually Low Inflation-adjusted Returns
Risk Medium to High Risk Low Risk
Liquidity Liquid Medium to Low Liquidity
Premature Withdrawal Allowed with Exit Load Allowed with Penalty
Cost of Investment Management Cost No Cost
Tax Status# Favourable Tax Status As Per Tax Slab
# Taxation details are as per existing tax laws. The nature of tax will depend based on the individuals tax status and nature of investments

  • In terms of Rate of Returns: while the interest rate offered on fixed deposits are pre-specified and fixed for the entire tenure, the returns on mutual funds may vary based on the market movement. While mutual funds offer you the benefit of market-linked returns, they have the potential to earn high returns in the form of capital appreciation during positive market conditions. On the other hand, fixed deposits would continue to offer you the same interest rates even if markets turned negative or positive. So usually mutual funds outscore fixed deposits during positive market conditions, and underscore fixed deposits during negative market conditions.

  • We all know that inflation eats a major chunk of our savings in terms of loss in the value of money. So you need to keep pace with inflation. Your investments would be worthy only if they are able to offer you decent Inflation-adjusted returns. Assume you have invested in a Fixed Deposit offering interest @ 9% p.a. while the rate of inflation is 8%; your inflation-adjusted return would be only 1%. It is quite obvious that you would like to look beyond this rate. Mutual funds have the ability to offer you better inflation-adjusted returns. But do not forget, they come with a relatively higher risk.

  • So what is the risk associated with these instruments? While bank fixed deposits are known for low risk, mutual funds carry market risk which is higher than fixed deposits. So you should consider your risk appetite while opting between bank's fixed deposits and mutual funds. Also, recognise that High Return comes with High Risk.

  • In terms of liquidity: Fixed deposits come with a fixed tenure and offer medium to low liquidity option until you complete the entire tenure of the deposit. On the other hand most mutual funds do offer liquidity to its investors but with certain conditions.

  • As we mentioned earlier, you may need to pay a penalty for premature withdrawal of your fixed deposits, where you would lose out a portion of your expected return. On the other hand, most mutual funds offer you high liquidity, once the minimum holding period is complete. In case you happen to withdraw immediately after your investment (usually within a period of 1 year), then you may have to pay an exit load which is usually around 1%. Exit load conditions may vary from one fund to another. So you should be aware about the exit clause of the mutual funds you are investing in.

  • Cost of investment / expenses: There is a cost associated with your investment in mutual funds and it depends on the category of mutual fund you are investing in. While a liquid fund may have a low expense of up to 1% p.a., debt mutual funds may have anywhere between 0.5% p.a. to 2.25% p.a., and the expense of equity mutual funds may be up to 3% p.a. This expense is adjusted in your returns. So the returns yielded are post expenses. On the other hand, bank fixed deposits offer an advantage on this parameter, as they do not levy any expense on the depositor. And you get the entire rate of interest promised by the bank.

  • Tax Status is an important aspect which should be considered while choosing between mutual funds and fixed deposits. You would agree that you will like to make high post-tax returns from your investment. In our previous session we told you about the tax implications on your mutual fund investment. The tax status of mutual funds is based on their category. While you need not pay any long term capital gain tax on your investment in equity mutual funds, the short term gain is taxable @ 15%. On the other hand your gains from long term investment in debt mutual funds (i.e. over a period of 1 year) is taxable @ 20% with indexation and 10% without indexation (whichever is lower); while your short term capital gain from debt and liquid mutual funds is taxable as per your tax slab. As far as fixed deposits are concerned, irrespective of the tenure, the interest which you earn thereon is taxable as per your income tax slab. So, as per the current tax laws mutual funds are quite tax friendly, provided you have held on for more than a year and you are in the highest tax slab.

The illustration here can help you understand the comparison better...

Mutual Funds vs. Fixed Deposits

  Fixed Deposits Debt Mutual Fund Equity Mutual Fund
Investment Amount 100,000 100,000 100,000
Return (% p.a.) 9.0% 9.0% 9.0%
Holding Period 1 Year 1 Year 1 Year
Fund Value 109,000 109,000 109,000
Inflation 7.5% 7.5% 7.5%
Indexed Investment Amount - 107,500 -
Taxable Income 9,000 1,500 -
Tax Paid (as applicable) 2,700 300 -
Post Tax Returns 6,300 8,700 9,000
Post Tax Returns (%) 6.3% 8.7% 9.0%
(Source: PersonalFN Research)
(The rate of return and rate of inflation is an assumption, for illustration purpose only)

  • ...Here are 3 scenarios which show an investment of Rs 1 Lakh each, in a bank fixed deposit, debt mutual fund and equity mutual fund. We've assumed in a given year, all 3 investments deliver a return of 9%. Further the assumption is that inflation will grow at 7.5% in the given year.

  • So you see... Rs 1 Lakh invested is now Rs 1.09 Lakh in each of the investment avenues. But in case of fixed deposits, with the interest income being taxable as per tax slab of an investor, the gain of Rs 9,000/- which the investor earns would further reduce to Rs 6,300/- assuming one happens to be placed in the highest tax slab of 30% (where he would have to pay a tax amounting to Rs 2,700/-). So the post-tax returns would be 6.3% in the given year in case of FD.

  • However, in the case of the debt mutual fund, with an indexation benefit available on account of long term capital gain (since having invested for over 1 year), the cost of investment is raised to Rs 1,07,500/- (due to inflation factor) instead of Rs 1 Lakh. Thus considering the indexed cost, the taxable gain would be Rs 1,500/- instead of the original gain of Rs 9,000/-. Here the investor pays long term capital gain tax @ 20% (as he has claimed indexation benefit) and hence the post-tax returns (over a period of 1 year) would be 8.7%, which is higher than the bank fixed deposit.

  • In the case of the equity mutual fund, the entire long term capital gain of Rs 9,000/- made on equity mutual fund is tax free and available to the investor, proving to be the most tax-efficient in the above illustration.

  • But you should choose your investment avenue wisely. Judge your risk appetite and investment time horizon well and understand your return expectation (which should be rational), before zeroing in on the type of investment avenue.

Now before we end our learning session today, here are some points you need to remember...

Points to Remember...

  • Fixed Deposits are traditionally a safe investment instrument that provide Rate of Interest higher than Regular Savings Account

  • Fixed Deposits are covered by the Deposit Insurance and Credit Guarantee Corporation (...or DICGC...), which guarantees an amount of up to Rs 1,00,000 per depositor per bank

  • The Rate of Interest on fixed deposits is fixed for a pre-specified Tenure (...FDs would continue to offer same interest rates irrespective of market conditions.)

  • Compared to bank fixed deposits, mutual funds have the ability to offer better inflation-adjusted returns (... to its investors. The returns on mutual funds are linked to market movement.)

  • Fixed deposits are suitable for investors with low risk appetite

  • (...While...) Mutual funds (...being subject to market risk...) are suitable for investors having relatively higher risk appetite

  • (While fixed deposits are less liquid...) Premature Withdrawal of fixed deposit may be allowed with a penalty (...which may harm expected returns)

  • Early redemption from mutual funds may be subject to exit load (...which in most cases is applicable for holding of less than 1 year)

  • (In terms of cost...) Fixed deposits are placed better than Mutual Funds

  • (While...) Mutual funds enjoy favourable tax status as compared to fixed deposits (...which means better post-tax returns for mutual fund investors)

  • (So you should...) Consider your risk appetite, investment time horizon and your return expectation (...along with other parameters...) while choosing between fixed deposits and mutual funds

So to end our learning exercise today, we now invite you to test your learning by taking up this simple quiz (and win exciting prizes!)

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