If you have saved up some money and looking to invest less risky financial instruments, then fixed deposits or debt mutual fund is your answer. But the similarity ends there. The two tools vary in many aspects like lock-in period and premature withdrawal/liquidity, capital protection, tax liability etc. here are some notable differences.
Lock-in period and premature withdrawal:
Debt Mutual funds have the no lock-in period or less (1 year) as compared to fixed deposits (5 years). In case the investment is prematurely in a debt mutual fund, an exit fee (0.25% - 1%) may or may not be charged depending on the fund invested. In FDs, a penalty is levied if you withdraw in advance. This penalty can be as high as 15%
FDs have a pre fixed interest rate that is not affected by the market movements. In debt mutual funds, the returns are based on the market. Historically, debt mutual funds have earned higher.
Returns from bank fixed deposits are interest income and as such have to be added to your normal income. Since many investors are in the top (30 per cent) tax bracket, this takes away a large chunk of their returns. Banks deduct TDS (Tax Deduction at Source) on interest income from. The tax rates are similar for debt funds held for less than 36 months (there is no TDS). However for debt mutual funds held for more than 36 months, returns are classified as long term capital gains and are taxed at 20 per cent with indexation.
Risk level and capital protection:
Fixed deposits have a reliable rating system that rates schemes as Sovereign, AAA, AA etc. to indicate how safe your invested capital is. Unlike the former, debt mutual funds do not have any rating system but the safety of the investment is determined by meticulous analysis and track record.
Also, debt mutual funds carry medium to high level of risk depending on the type of fund and market conditions whereas FDs carry low to medium risk, which will be indicated in its rating.
Debt mutual funds have the option to pay out dividends periodically as a form of income. However, there is no such option in fixed deposits.
Let us compare the returns between a debt mutual fund (Aditya Birla Sun Life banking & PSU Debt fund – Regular – Growth) and a fixed deposit.
An amount of ₹10000 has been invested for a period of 5 years since January 2012 in both FD and Debt mutual fund, let us compare the income yielded by the two implements in the below chart:
Presume that the fixed interest was compounded quarterly at a rate of 9%. The mutual fund returns were 9.25% on average. After five years, fixed deposits yielded about ₹5605 as interest while debt mutual earned up to ₹9831 as interest.
It is very clear from the illustration that debt mutual funds provide you more wealth. Ultimately your decision should be based on your risk appetite and financial goals. But when looking in the long run, mutual funds always provide higher returns than any other investment because of its power of compounding while also providing tax free income.