Fixed deposits or debt funds: Which is better for your money

Fixed deposits and debt mutual funds are among the most sought-after in conservative investor schemes. Both are safer than equities but vary in the manner in which they earn a return, how they are taxed, and what kind of flexibility they offer. Understanding these differences is crucial before deciding on which one is suitable for your financial goals.

Safety v/s market-linked returns

Fixed deposits (FDs) are highly trusted because they offer returns assurances. When you put money into an FD, the bank fixes a guaranteed rate of interest over the term, regardless of market fluctuations. They become sure and reliable, especially for risk-averse savers. Debt mutual funds are not the same. They raise money from the investors and invest this money in government securities, corporate debt, and money market instruments. Their returns are market-related, i.e., they fluctuate with interest rates and creditworthiness of bonds purchased by them. Debt funds of high quality are stable, but there is some risk associated with them compared to FDs.

Liquidity and flexibility

FDs carry a lock-in period, and it is generally charged to withdraw them before maturity. This reduces their appeal if you need quick access to money. Debt funds offer much higher liquidity. They can be redeemed at any point in time by the investors, and the money would normally be credited within a day of working if it is liquid funds. They are thus ideal for parking cash for the short term or for investors requiring easy access. However, the redemption value of debt funds depends on the market situation, and so you may not always get the same value that you expect at the withdrawal.

Tax efficiency

The taxability of FDs and debt funds is a key differentiator. Interest on FDs is taxed as part of your income and at your tax slab rate, up to 30%. This lowers the after-tax return for those at higher tax brackets. Debt funds are taxed as capital gains. If you offset them in three years, gains are short-term and attract tax at your slab rate. If you have them for more than three years, they qualify for long-term capital gains tax with indexation benefits. Indexation adjusts the cost price for inflation, lowering taxable gain and often making debt funds tax-efficient for long-term investors.

Who makes the decision?

The choice between FDs and debt funds is according to your purpose and risk tolerance. If safety, guaranteed returns, and convenience are your preferences, then FDs are your best bet. They are appropriate for retirees, senior citizens, or others who do not want to take a risk related to market movements. Debt funds are apt for those who want more liquidity, perhaps better post-tax returns, and are ready to compromise on limited risk. They also suit investors looking for short- to medium-term investment horizon with ready accessibility of their money.

FAQs

1. Are debt funds riskier than FDs?

Yes, debt funds involve credit and interest rate risks. But the funds with investment in high-grade government securities or liquid funds are more conservative than equity investment.

2. What is better suited for short-term needs?

For very small time frames of, say, less than six months, FDs may be more convenient. For three to six months and three to three years time periods, debt funds—specifically liquid or ultra-short duration funds—can offer more flexibility and returns.

3. Can I lose money in a debt fund?

Yes, you can, especially if the prices of bonds go down or a borrower fails to repay. But government-backed debt funds carry very low default risk and are safer than most other market-linked products.