If you ask someone whether Fixed Deposits are better or Debt funds are better, more likely than not, you will hear a biased answer towards either of them. Some swear by FDs and their safety, while others say debt funds always give better returns than FDs. Lets bust some myths and try to get an understanding of how these two types of investments work.

Before going any further, if you are eligible for Senior Citizen Saving Scheme (SCSS), then I would say that is the best fixed asset option for you, if your investment is less than Rs. 15 lakhs. SCSS out of the way, now we are ready to butt FDs against Debt funds. Since there are various characteristics of fixed assets (risk, returns, liquidity, taxation etc), we will go over each of them and compare Debt vs FD. Finally, we will take some examples and compare them to see which fits you better.

## Risk

When it comes to safety of your investment, Fixed Deposits win over Debt funds hands down. Even the very safe Liquid Debt Funds are not as safe as Fixed Deposits. There are a couple of risks that affect Debt Funds. One is the interest rate risk and the other is default risk. In the case of Fixed Deposits, you are always sure of the exact rate of return. But in the case of Debt Funds, a change in interest rates will affect your return. When interest rates go up, Debt funds lose out on the returns and vice-versa. The interest rate risk is least in liquid funds, and the highest in long term debt funds. Consequently, long term debt funds have better return compared to liquid funds.

The other kind of risk that affects Debt funds is default risk, because the borrower of a loan can default on the payments or go bankrupt. This happened recently with an NBFC which was rated at investment grade and later dropped to junk rating in a short duration (read about the ILFS crisis). Banks rarely default (there are some cases of co-operative banks defaulting), so you Fixed Deposits are safe. If safety of your investment is of utmost importance to you, then keep your investments in Fixed Deposits.

## Returns

Debt funds returns are generally better than Fixed Deposits. Ultra-short term funds have a nice balance of minimal interest rate risk with the upside of slightly better returns than Fixed Deposits. Note that the low interest rate risk Debt Funds (such as ultra-short term funds) don’t give much better returns than FDs. But they have their benefits (as you will note below). So, while deciding between Debt Funds and FDs, returns should not be too high in the list.

## Liquidity

One of the benefits of Debt Funds is that they are very liquid without affecting your returns. In the case of FDs, you have to pay a penalty if you redeem before the maturity date. While some longer term Debt Funds have an exit load if redeemed with in a year, most ultra short term funds don’t. So, if you are not sure if you might need the money unexpectedly, prefer Debt Funds. Generally longer term FDs offer better returns, but you have to be sure that you will not need the money in the interim.

## Taxation

Here comes another big difference between Debt funds and FDs other than the safety. FDs are not as tax efficient as Debt Funds in the long term. If you hold Debt Funds for more than 3 years, you are taxed at 20% **after indexation**. Where as FDs are taxed at your marginal rate no matter how long or short you hold it. The reason is that the interest you earn from FDs are added to your income every year, even if the FD period is more than a year. So whether you take a 5 year FD or 6 month FD, you are taxed at your marginal rate on the interest that you earned in that year. Whereas for Debt Funds, you are only taxed on redemption. So, if you have no income or your tax rate is very low like 5%, then FD may be a better option for you given that you have safety and returns almost like Debt Funds, but only if you don’t need the liquidity. While you are better off with Debt Funds if you don’t need the money for more than 3 years and can handle the small volatility that comes with them.

## Examples

Lets take a couple of examples to see how one could benefit from one over the other. Assume a **7.5% return on FD** and **8.0% return on Debt Funds** and you want to **invest Rs. 10 lakhs**.

### Example 1

Your **income from other sources is Rs. 1.7 lakhs per year** and you fall into 5% tax slab once your income exceeds Rs. 2.5 lakhs. You don’t need the money for **5 years**. You invested from 2013 to 2018.

#### FD Returns

**Year 1**

Interest = 7.5% * Rs. 10,00,000 = Rs. 75,000

Total Income = Rs. 1,70,000 + Rs. 75,000 = Rs. 2,45,000

Tax = 0

**Year 2**

Interest = 7.5% * Rs. 10,75,000 = Rs. 80,625

Total Income = Rs. 1,70,000 + Rs. 80,625 = Rs. 2,50,625

Tax = 5% of 625 = Rs. 31

**Year 3**

Interest = 7.5% * Rs. 11,55,625 = Rs. 86,671

Total Income = Rs. 1,70,000 + Rs. 86,671 = Rs. 2,56,671

Tax = 5% of 6,671 = Rs. 333

**Year 4**

Interest = 7.5% * Rs. 12,42,296 = Rs. 93,172

Total Income = Rs. 1,70,000 + Rs. 93,172 = Rs. 2,63,172

Tax = 5% of 13,172 = Rs. 658

**Year 5**

Interest = 7.5% * Rs. 13,35,468 = Rs. 1,00,160

Total Income = Rs. 1,70,000 + Rs. 1,00,160 = Rs. 2,70,160

Tax = 5% of 20,160 = Rs. 1008

Total value after 5 years is Rs. 14,35,628 (FD maturity value) – Rs. 2,030 (total tax paid) = **Rs. 14,33,598**

#### Debt Fund Returns

Value after 5 years = Rs. 14,69,328

Cost inflation index for 2013-14 = 220

Cost inflation index for 2018-19 = 280

Inflation indexed cost = 280 / 220 * Rs. 10,00,000 = Rs. 12,72,727

Capital gain = Rs. 14,69,328 – Rs. 12,72,727 = Rs. 1,96,600

Total Income = Rs. 1,70,000 + Rs. 1,96,600 = Rs. 3,66,600

Tax paid in 5th year = Rs. 1,16,600 * 20% = Rs. 23,320

Total value = Rs. 14,69,328 – Rs. 23,320 = **Rs. 14,46,008**

You made almost the same amount with Debt funds as with FDs. But in this case you may prefer FDs since they are safer.

### Example 2

Your income falls into the highest **tax bracket of 30%**. You don’t need the money for 5 years. You invested from 2013 to 2018.

#### FD Returns

**Year 1**

Interest = 7.5% * Rs. 10,00,000 = Rs. 75,000

Tax = 30% of Rs. 75,000 = Rs. 22,500

**Year 2**

Interest = 7.5% * Rs. 10,75,000 = Rs. 80,625

Tax = 30% of Rs. 80,625 = Rs. 24,187

**Year 3**

Interest = 7.5% * Rs. 11,55,625 = Rs. 86,671

Tax = 30% of Rs. 86,671 = Rs. 26,001

**Year 4**

Interest = 7.5% * Rs. 12,42,296 = Rs. 93,172

Tax = 30% of Rs. 93,172 = Rs. 27,951

**Year 5**

Interest = 7.5% * Rs. 13,35,468 = Rs. 1,00,160

Tax = 30% of Rs. 1,00,160 = Rs. 30,048

Total value after 5 years is Rs. 14,35,628 (FD maturity value) – Rs. 1,30,687 (total tax paid) = **Rs. 13,04,941**

#### Debt Fund Returns

Value after 5 years = Rs. 14,69,328

Cost inflation index for 2013-14 = 220

Cost inflation index for 2018-19 = 280

Inflation indexed cost = 280 / 220 * Rs. 10,00,000 = Rs. 12,72,727

Capital gain = Rs. 14,69,328 – Rs. 12,72,727 = Rs. 1,96,600

Tax paid in 5th year = Rs. 1,96,600 * 20% = Rs. 39,320

Total value = Rs. 14,69,328 – Rs. 39,320 = **Rs. 14,30,008**

In this case you would have made **Rs. 1.25 lakhs more than FD**. Probably the additional risk is worth it?

Hope this helps you decide which way to go. Sometimes Debt Funds are better and at other times FD is better. You need to take a call on a case by case basis.

Future post request: how to go about choosing a good debt fund with quality, liquidity and reasonable returns?

Most certainly

As far as I know, most of the banks (if not all) shied away from penalizing customers for premature closure of FDs. There is no extra penalty other than prorated Interest rate for the FD period (until closed). And yes, looking forward to some tips and good debt funds to choose ðŸ™‚