Inside: What lends debt mutual funds an edge over fixed deposits

When it comes to saving for the long-term, fixed deposits (FD)often reign supreme as the go-to instrument for Indian households. After all, the investment option guarantees returns at comparatively low risk, making it a secure way of building a corpus. However, the recent upswing in investment alternatives like mutual funds, accompanied by declining FD rates, has caused many people to change their preferences.

Let’s understand why debt mutual funds have an edge over fixed deposits.

Understanding debt mutual funds

Debt funds invest in fixed income instruments such as government securities, corporate bonds, commercial papers, certificates of deposits, etc. These are low-cost mutual funds that are known for generating relatively stable returns. Ideal for risk-averse or low-risk investors, debt funds can be suitable for both long-term and short-term goals. They can be viewed as an alternative to fixed deposits since they offer an opportunity to earn higher returns on savings.

Apart from comparatively higher returns, debt mutual funds provide quite a few other benefits that fixed deposits don’t. Before understanding them, let’s quickly take a look at the basic differences between the two.

Debt mutual funds vs. fixed deposits

Particulars Debt funds Fixed deposits
Meaning A mutual fund that invests in fixed income securities An account that locks your money for a fixed period in exchange for a fixed return
Mode of investment Either lumpsum or in instalments through Systematic Investment Plans (SIPs) Only lumpsum investment
Liquidity Comparatively high Comparatively Low
Withdrawals Allowed with or without an exit load depending on the scheme Premature withdrawals attract penalties
Risk Moderate to low Low
Taxation Short-term capital gains and long-term capital gains are taxed differently; long-term gains tax comes with indexation benefit All returns are taxed as per the income slabrate

Now that we understand the differences, let’s look at the two key factors that make debt funds more profitable than FDs.

  • Taxation

In the case of FDs, the entire accrued interest for a particular financial year is taxable as per your slab rate.

For debt funds with a holding period of three years or less, your gains on redemption will be taxed as per your slab rate. However, if you redeem the fund units after threeyears, your gains will be classified as long-term capital gains and accordingly taxed at 20% with indexation benefits. Therefore, long-term debt fund investments can be more tax-efficient than FDs.

  • Inflation adaptability

To be able to beat inflation, your investment must fetch returns higher than the inflation rate. However, this is less likely in the case of FDs that offer fixed returns. For example, you start an FD for a laptop worth Rs 2 lakh, and the maturity amount after 5 years will be Rs 2,10,000.Your investment will not serve the purpose if inflation increases the cost of the laptop to Rs 2,30,000. However, if you invest in debt funds that have the potential to deliver higher returns, you may be able to counter inflation and meet your goal.

Another benefit of debt funds is that they offer indexation benefits. This means your purchase cost of investment is adjusted for inflation at the time of redemption. An increase in your investment amount will lead to a decrease in your capital gains while calculating your tax liability. Ultimately, this will mean lower tax outgo for you.

Bottom line

Debt mutual funds and FDs are both looked at for meeting short-term goals. However, the former has the upper hand in more than one aspect when compared to the latter. This explains the growing popularity of debt mutual funds.