Difference Between a Fixed Deposit and a Debt Mutual Fund

For decades, fixed deposits have been the go-to for Indians. However, recently, the popularity of debt mutual funds has increased. If you are a new investor, you might wonder which option is better. Read more to understand what fixed deposits and debt mutual funds are and the difference between them.

Understanding Fixed Deposits

A fixed deposit is one way to invest. Here, you invest a sum of money in a bank for a fixed period. You are guaranteed to get this sum back at the end of the term (maturity period), along with interest. The rate of interest is chosen at the beginning. 

You are lending money to the banks, which use this sum to grant loans to others. A part of the interest they receive from these loans is given to you. You can invest in fixed deposits or term deposits for a short-term or long-term, ranging from 7 days to 10 years. 

You can only make one type of deposit with FDs. You must pay the penalty if you wish to withdraw money from your FD before maturity. 

Types of Fixed Deposits

• Non-cumulative FDs 

Here, the banks will give you interest at fixed intervals of your choice. It can be monthly, quarterly, half-yearly, or annually. Thus, you will have a regular income from the FD. 

• Cumulative FDs

You can choose to reinvest the interest every year. Here, you do not have the provision to get regular payouts. Instead, the total interest, along with the principle, is returned at maturity. You can earn a higher profit due to compounding. The interest for the following year will be calculated based on the principle plus the interest from the previous year.

Features and Benefits of Fixed Deposits

• Easy to liquidate

In an emergency, you can easily liquidate your FD and obtain funds. However, withdrawing from an FD before maturity is better avoided as it significantly reduces returns.

• Minimal risk and assured returns

Once the amount has been deposited at a specific interest rate, it is unaffected by any changes in interest rates or market fluctuations. Thus, the returns are assured.

• Low minimum investment 

If you want to try investing but don’t have a large amount, FDs are a good option. This is because investment amounts can start as low as Rs. 500.

• Easy to invest

FDs are easy to invest in, both offline and online, either through net banking or mobile banking.

• Senior citizen benefits

People over 60 are offered a higher interest rate on fixed deposits and have a tax benefit. If the source is less than ₹50,000 per year, their interests are not tax-deductible at the source. 

• Other benefits

There are several other benefits, like loans against FD. You can avail yourself of loans of up to 90% of the deposit in your FD at very low-interest rates. You can get tax deductions by investing in tax-saving fixed deposits. 

Understanding Debt Mutual Fund 

In debt mutual funds, the asset management company invests your funds in fixed-income debt instruments. You are giving loans to governments (as bonds or treasury bills), corporations (as bonds or commercial papers), or financial institutions (as certificates of deposit or debentures). They are also known as fixed-income funds or bond funds.

These entities promise to pay back the principal after some time, along with interest. However, the ability to uphold this promise varies from company to company, resulting in a credit risk associated with the investment. The risk you have depends on the type of borrower and the lending duration.

Sources of Income

A debt fund has 2 sources of income:

• Interest Returns  

You get interest from the bond holdings, called coupon income. 

• Capital Gains

You can trade debt instruments. If the bond price increases, selling the bond will result in a profit. The bond’s price changes when the bond’s interest rate changes. This results in a gain or loss of capital. 

If the bond’s interest rate decreases after you buy it, your bond with a higher interest rate becomes more valuable. With this, your bond price increases. Thus, bond prices move in the opposite direction of interest rates.

The type of bonds determines the income a mutual debt fund earns through capital gains and interest. When market yields drop, the price of long-term bonds inflates more than that of short-term bonds, and when market yields climb, long-term funds lose more value. 

So long-term bonds are more likely to make capital gains or losses. For short-term bonds, the income is mainly from interest, as capital gains and losses don’t impact it much.

Features and Benefits

• Access to market returns and professional expertise

Investing in a debt fund gives you two possible sources of income: interest and capital gains. It also allows retail investors to access wholesale debt markets or money markets. These are segments where they cannot directly invest.

• Balances your portfolio

Debt funds have less risk. It helps with portfolio diversification.

• Variety of investment options 

There are many different types of debt funds available along the entire spectrum of maturity and credit risk to match your needs. You can invest in debt funds for as little as one day or for as long as three years.

• Liquidity

You can easily cash debt funds, usually within one or two working days. There are usually no penalties involved when a mutual fund investment is withdrawn prematurely.

• Low-Cost Investment

As per SEBI norms, the total expense ratio of a mutual debt fund cannot surpass 2% of assets under management.

Difference between FD and Debt fund

Fixed Deposits	Debt Mutual Funds
You make a one-time deposit to a bank or NBFC for a fixed period. The rate of interest is predetermined.	Debt funds are invested in debt instruments like bonds. The entities that issue the debt securities promise to pay their investors a periodic interest for the money invested.
There is only one source of income, which is interest.	There are two sources of income: interest returns and capital gains.
The bank is the borrower, and you are the investor. Here, you earn interest.	Debt funds are the investors. Here, the debt funds earn the interest.
Fixed deposits have assured returns. They are 100% safe.	Periodic interest payments to fixed-income mutual debt funds can be variable or fixed. There is no guarantee. There is always some risk involved.
Low net gains	Better for short-term investments compared to FDs as they offer a higher net return.
Less tax efficient and thus less post-tax returns	More tax efficient and thus earn better post-tax returns
Fewer investment options	Wide range of investment options

Conclusion

Fixed deposits and mutual debt funds are two ways to invest. Although they operate similarly, there are differences between them. Before investing, decide on the risk you are willing to take, the investment period, and your financial goals. Go through the various FD or mutual debt fund schemes and select the ones that match your needs. 

Visit Piramal Finance to know more.