I hardly have any Fixed Deposits. I once did but after I discovered Debt Mutual Funds, I rolled over all my money from FDs to them.
Short Term Debt Mutual Funds are quite safe - almost as safe as FDs
Good Short Term Debt Mutual Funds invest in high quality interest-bearing short-duration bonds. Their risk is spread over several high quality companies whereas in case of FD your entire risk is concentrated in only one company - your bank. (FDs are insured only upto 1 lakhs - after that it is all dependent on how solvent your bank remains over time). Most corporates and HNIs use Debt funds to park their surplus cash and not FDs.
What about returns?
Returns from Short Term Debt Funds are similar to that of FDs. As of writing this, both FDs and Short Term Debt Funds have yields close to 7% pre-tax. Both of them respond to interest rates set by RBI from time to time. With FD the interest rate gets locked-in at the time of making the FD and with Debt Funds it changes as per RBI's policy on a floating basis.
So far they look almost the same. Why do I prefer Debt Funds over FDs then? Here is why -
1. No need to decide number of years upfront
I usually don't know how long I will not need my surplus cash for. I just want to park it somewhere and earn better returns than my savings account without bothering with how many years I want to lock it in for. With Debt Funds I can do just that - invest as I please without having to predict the future.
2. No exit loads, no penalties
Not only can I invest as I please, I can also withdraw as I please without having to pay any exit loads or penalties common in FDs. In FDs not only there is a penalty but even the interest rate gets revised depending on how soon you withdraw from it whereas in several good Short Term Debt Funds there is no exit load at all - even if I just want to invest for a week.
3. Partial withdrawals allowed
I don't need to 'break' the entire investment if I just want to use a part of it. Only the amount that I need to use can be withdrawn (without any penalties) and the rest will stay invested earning interest. As flexible as it gets!
4. Similar pre-tax returns but higher after-tax returns
A very important reason why Debt Funds make more sense than FDs - lower taxes in the long term!
The interest income from FDs is taxable at your income slab rate i.e. if you are in the 30% income tax bracket, the tax payable on your FD is 30% of the interest received. This is irrespective of how long your FD is for.
In Debt Funds, the gains are taxed as capital gains i.e. for the first 3 years they are taxable at your income tax level (same as FD) but if you invest for more than 3 years then you get to pay tax only on the gains above inflation (known as indexation benefits), that too at a flat 20%.
For e.g. consider a 3 year FD vs a 3 year investment in Debt Funds both giving 7% pa interest and inflation being 6% during those 3 years. In case of FD all of the interest income will be taxable. At 30% income slab, your post tax annual returns are 7% - 30% tax = 4.9%
In case of Debt funds since the investment period is 3 years, the tax is payable only on the part above inflation rate i.e. 7%-6% = 1%. Tax is 20% of 1% = 0.2%. Your post tax returns are 7% - 0.2% = 6.8% (much higher than the 4.9% in FD).
These are approximate figures. The exact calculations are done slightly differently and you can refer here for that but you get the point.
5. No TDS (Tax Deducted at Source)
In FDs, 10% tax on the interest is deducted by the bank itself from your account every year (usually on 31st March) even when your FD has not matured. The balance tax has to be paid by you anyway separately. This TDS is not just annoying but also lowers your final returns because now you have lesser amount going forward in the next year. In Debt Funds there is no such TDS, not even when you finally withdraw the money (tax is still payable by you).
6. Bonus reason - Daily interest income (instead of quarterly)
In FDs you get interest quarterly whereas in Debt Funds you get it daily leading to higher compounding (all else being the same). Again a small difference but a difference nevertheless.
Which are the recommended Short Term Debt Funds I am investing in?
Here are three -
- Baroda Pioneer Treasury Advantage Fund - Growth
- IDFC Ultra Short Term Fund-Growth
- SBI Ultra Short Term Debt Fund - Growth
All of these have no exit loads and have current yields of around 7%.
These three funds are also the recommended funds in our Smarter Savings goal and can be invested in with a click of a button. :)