The traditional investment choice for most Indian households is Fixed Deposits. Research done by RBI in the year 2020, shows 53% of average retail financial assets are invested in Bank FDs (as of March 2020). As per records, mutual funds have a long history in India with the formation of Unit Trust of India in 1963, as mentioned earlier in the blog post, the mutual fund's popularity among retail investors has gone up in the last 20 – 25 years. As per Association of Mutual Funds data, the AUM of mutual funds in India has grown at a CAGR of nearly 17% over the last 20 years. Despite the rapid growth, As per the research done by RBI suggests that Mutual funds comprise only 7% part of household savings. In this post, we will find the comparison between FD vs Mutual funds for making decisions on whether to invest in FD or mutual funds.
How do Fixed Deposits work?
The meaning suggests Fixed Deposits or FD's offer fixed interest rates to the investors for a fixed period of time, FD tenures have a range from 7 days to 10 years. Bank FD interest is compounded, i.e. you receive interest in the form of accrued interest. Let us find out by an example, let us assume a bank pays 6% interest (compounding annually) for 3 years FD. A deposit of Rs 100, after a 1-year account, will have Rs 106. In year 2, you will get 6% interest on principal plus the interest, i.e. 6% on Rs 106 or Rs 6.4. The extra 40 paisa you receive is due to compounding.
In the case of senior citizens, who invest their lifetime savings primarily in FDs in the declining interest rates scenario, which has declined over the past 25 years (as per the chart below). With RBI cutting interest rates aggressively in the wake of the COVID-19 outbreak, resulting in banks reduced FD interest rates. On a post-tax basis, FD interest rates at present are barely able to beat inflation. FD interest is taxed as per the income tax slab as per individual depositors. Since the FD interest rate is fixed over the FD tenure, indexation benefit is not applied in taxation. Hence, we can conclude that in FD's there is no protection from inflation, especially when FD interest rates are so low.
In debt funds, short-term capital gains (held for less than 36 months) are taxed as per the income tax slab of the individual investor, and long-term capital gains (held for more than 36 months) are taxed at 20% after allowing the benefit of indexation. Therefore, if we compare debt mutual fund vs fixed deposit comparison, debt mutual funds score higher.
This post has seen the difference between FD and the mutual fund from a risk point of view. FDs assured guaranteed returns while mutual funds are subject to market risks. if you evaluate your risk appetite and invest accordingly, mutual funds will be good investment options in a declining interest rate scenario. Indexation in long-term capital gains taxation of debt funds has given mutual funds a significant advantage in taxation with the comparison with FDs. You should evaluate your financial goals and risk appetite to take a step forward and take a correct investment decision.