FD interest rates set to rise further, but are debt funds a better choice?

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Updated: August 12, 2018 9:14:19 AM

Financial experts say that although FD rates are now going up and may become more attractive in the months to come, still debt funds may not be a bad option.

Bank FD, debt fund, FDs Vs debt funds, fixed deposits, FD vs debt fund, better returns, FD interest ratesFD Vs Debt Mutual Fund: It may be noted that long-term debt funds are taxed at 20% with indexation benefit.

After a long time, fixed deposit interest rates have started rising again, which is good news for investors looking to park their funds in bank FDs. For instance, India’s leading banks — including the State Bank of India (SBI) and HDFC Bank – have recently hiked their fixed deposit rates, ranging from 0.05 to 0.60 percentage points, and the rates may again be revised in the coming months, which will surely give investors better returns.

However, financial experts say that although FD interest rates are now going up and may become more attractive in the months to come, still debt funds may be a better option for investors.

“Even as interest rates on fixed deposits are noticing an upward shift, many investors prefer investing in debt funds over FDs, given that they outscore over the latter on various grounds, including liquidity, investment route and tax efficiency,” says Manish Kothari, Director & Head of Mutual Funds, Paisabazaar.com.

Adhil Shetty, CEO, Bankbazaar.com, also says that the main drawback of FDs is that they are not tax-efficient. “Banks revising their deposit rates certainly makes FDs attractive for consumers. However, they are not exactly tax-efficient. Your FD interest income is clubbed with your income and taxed as per your slab. Not just that, the interest rates are rising in response to increasing inflation. Therefore, a 7% FD with a 5% inflation rate is effectively earning you 2%, and when you consider the impact of taxation, your returns are even worse,” he says.

How FDs and debt funds are taxed

It may be noted that long-term debt funds (held for a period of 36 months or more) are taxed at 20% with indexation benefit. Indexation takes inflation into account during the holding period of the asset and raises its acquisition price accordingly. This reduces the overall gains and, consequentially, pulls down tax outgo to even nil (in times of high inflation).

“On the contrary, interest income which one gets from FDs is fully taxed as per the rate corresponding to one’s income tax slab. Its gains can be taxed at 30% in case of those who fall under the highest tax slab. This can take away a major chuck of your returns,” says Kothari.

Also, withdrawals from fixed deposits before the maturity date usually carry premature withdrawal fee/penalty. In case of debt funds redeemed before the completion of pre-specified period, an exit load may be levied, depending upon the fund type. Usually, “short term, ultra short term, liquid funds and other low/short-duration funds do not charge any exit load, and thereby offer greater flexibility. This makes them a preferred option over fixed deposits to park emergency funds and money for short term goals such as family vacation,” observes Kothari.

Moreover, investor can only invest a lump sum amount in FDs, whereas debt funds offer the facility of both SIP (Systematic Investment Plans) as well as lump sum investment.

Which is a better option and what precautions to take?

Keeping these facts in view, one can alternatively explore short-term debt funds like liquid mutual funds which have returns comparable to FDs, but are more tax-efficient if held for three years or longer due to the availability of indexation benefit on long-term capital gains.

However, “one must remember that all debt mutual funds are not the same. Different schemes in this space serve different purpose. Some are meant for short-term investment, whereas others are meant for long-term investment,” says Shetty.

Also, change in interest rates environment has a big impact on long-term debt mutual funds. A rising rate scenario is bad news for most debt funds because of the inverse relationship between yields and prices of bonds. When interest rates rise, the bond prices fall, and so the NAVs of long-term debt mutual funds fall.

It is, thus, advisable to stay from long-term debt funds in the current market scenario.

Moreover, “before deciding upon your choice of investment, make sure you take into consideration factors such as your risk appetite, investment horizon, expected returns, liquidity, taxation etc. While opting for debt funds, opt for their direct plans rather than regular plans, as they generate higher returns,” suggests Kothari.

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