Bank Fixed Deposit Rates Reach Record High: Know How Debt Mutual Funds Fare Against Bank FDs

As bank FDs reach record highs, let's compare the pros and cons of both bank FDs and debt mutual funds
Bank Fixed Deposit Rates Reach Record High
Bank Fixed Deposit Rates Reach Record High

State Bank of India (SBI), HDFC Bank, Union Bank of India and several others have hiked interest rates on fixed deposits in the last month by 25 bps to 75 bps on several tenures.

Experts suggest that fixed deposit interest rates are currently at a 10-year high. They feel that a repo hike of 250 bps between April 2022 and April 24, is almost transmitted completely into fixed deposit rates, which suggests no more room for hikes So conservative investors considering this option should consider locking in at the current rates. However, there are other angles to consider for those looking for alternative fixed-income options. Debt investment options, particularly debt mutual funds are a popular alternative to fixed deposits. Let's compare the pros and cons of both these investment options

Fixed Deposit vs Debt Mutual Funds: Pros & Cons

Basavaraj Tonagatti, a certified financial planner (CFP) said, "If your investment horizon is brief (e.g. 1-2 years), maintaining fixed deposits in the bank is the suitable option."

"On the other hand, for long-term goals, debt mutual funds offer better prospects. Despite the identical tax treatment, Debt Mutual Funds outperform Bank FDs for long-term investors. This is primarily because in mutual funds, taxes are only applicable upon withdrawal, and there is no TDS deduction. This advantage is not present with Bank FDs," Tongatti said.

Volatility or Interest Rate Risk: Fixed deposits are popular as an investment avenue offering guaranteed returns, and a fixed income that is not impacted by the volatility of markets. Once you park funds at a particular interest rate, the bank is liable to pay you that amount till the maturity of tenure or renewal of the deposit.

Debt mutual funds carry high volatility in yields due to interest rate fluctuations compared to bank FDs. For instance, the repo rates were increased after COVID-19, and the returns from debt mutual funds have slumped and still have not recovered to that level. However, the returns have still stayed between 7 per cent to 10 per cent, averaging to better sum than fixed deposit.

Credit Risk: The bank fixed deposits are covered by RBI's Deposit Insurance and Credit Guarantee's insurance up to Rs 5 lakh. There is very little credit risk attached to debt mutual funds as gilt funds or long-term funds are only investing in government bonds and those investing in corporate bonds also have little credit risk attached to it.

Taxation: Both debt mutual funds and bank fixed deposits are taxed according to the investor's income tax slab rate. However, Tax Deducted at Source (TDS) is deducted in each instance of a fixed deposit maturing and getting renewed. On the other hand, renewed, with debt mutual funds, there is no TDS deducted. A debt mutual fund is only taxed when an investor redeems the units.

Further investments in tax-saving fixed deposits are exempt under Section 80C of the Income Tax Act. So an investor can claim up to Rs. 1.5 lakh as a deduction per annum by investing in a tax-saving fixed deposit account. Conversely, debt mutual funds lack such exemptions. However, for those in higher income tax brackets, a debt mutual fund can prove advantageous in the long run, compared to a normal bank FD.

Liquidity: Once you are in emergency need of funds during a weekend, redemption of units from a debt fund redemption will not be possible. Saturdays and Sundays are not considered business days for mutual funds. However, Fixed deposits, allow you to prematurely withdraw your deposit even on some Saturdays, but a certain penalty will be levied ranging between 0.5 per cent to 1 per cent as premature withdrawal charges.

Returns: Debt mutual funds have a slight edge over fixed deposits when it comes to returns. Large banks are providing 7 per cent to 7.25 per cent to general citizens as their highest interest rate on select tenures.

The ICICI Prudential Gilt Fund delivered 8.10 per cent topping the 5-year returns. Over one year and three years, it delivered 8.13 per cent and 6.60 per cent respectively. SBI Magnum Gilt Fund grabbed the second spot and delivered a solid 7.99 per cent in five years, 7.49 per cent in one year and 6.49 per cent in three years. Lower supply of government bonds and inclusion of government bonds in JP Morgan Government Bond Index-Emerging Markets (GBI-EM) from June 24 2024 is expected to bring down the yields further and improve returns of debt mutual funds. Further, as interest rates are expected to be lowered in the second half of 2024, new debt fund investors can expect more returns.

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