Bank FD Vs. Mutual Funds: Which Is Better?

Mar 30, 2017

Since the beginning of 2015, the Reserve Bank of India (RBI) has reduced policy rate by 175 basis
points (bps). Consequently, banks, too, have reduced interest rates on Fixed Deposits (FDs). If
inflation mellows down further, the rates are expected to drop lower.

Such a scenario has got many investors, especially the ones averse to risk worried. They’re wondering
where they should park their hard-earned money. One-year bank FD rates are currently in the range
of 5.25%-7.00%, but if you’re placed in highest tax bracket (of 30%), a paltry sum is earned. This
further gets eroded when inflation – which is hovering around 5.00% -- is accounted for over the past
year. So, the effective real rate of return (also known also as inflation-adjusted return) has clearly
become unimpressive.

Therefore, many investors are exploring various investment avenues looking for better returns. A
comparison is being made between bank FDs vs. mutual funds — although this is alike to comparing
apples with oranges.

Here are some points of distinction between the two investment avenues:

Risk-Return: It is vital to recognize that investing in mutual fund schemes commands a higher risk
vis-à-vis bank FDs (and small saving schemes). While the interest rate offered on bank FDs are
pre-specified and fixed for the entire tenure, the returns on mutual funds may vary based on the
market movement. Hence the disclaimer: “Mutual fund investments are subject to market risks, read
all scheme related documents carefully.”

Given the market-linked nature of mutual funds, the return potential hinges on market conditions
and how efficiently the fund manager manages the portfolio. Usually, mutual fund schemes outscore
during positive market conditions, and underscore bank FDs during negative market
conditions. So you should consider your risk appetite while opting between bank's fixed deposits and
mutual funds. Mutual funds unlike, bank FDs do not come with insurance and credit guarantee. DICGC
provides guarantees an amount of up to Rs 1,00,000 per depositor per bank - for both principal and
interest.

Real rate of return: Over the long-term, mutual funds, particularly the equity-oriented ones are an
effective in beating the inflation bug. Meaning, they hold the potential to clock a decent real rate of
return (also known as the inflation-adjusted returns). But selecting the best or winning mutual
funds is a critical task.

Liquidity: Mutual funds have high liquidity; but, of course, it depends on conditions such as type of
the scheme opted for – whether open-ended / close-ended, lock-in period, exit load, performance of
the scheme, etc. Whereas, in case of bank FD liquidity is bound by the tenure of the FD. The option to
prematurely withdraw a bank FD is of course available; but you would lose out a portion of your
expected return, and a penalty is charged. Thus bank FDs offer medium-to-low liquidity.

Cost of investing: In case of mutual funds, cost of investing clearly depends on the category of mutual
fund scheme you are investing in. While a liquid fund may have a low expense of up to 1% p.a., debt
mutual funds may have anywhere between 0.50% p.a. to 2.25% p.a., and the expense of equity
mutual funds may be up to 3.00% p.a. The expense ratio has a bearing on returns, as the return yields
are post-expenses. On the other hand, bank fixed deposits offer an advantage on this parameter, as
they do not levy any expense on the depositor. And you get the entire rate of interest promised by
the bank.

Tax implication: This is an important aspect while choosing between mutual funds and fixed
deposits. For mutual funds, the tax status depends on the category of mutual fund – equity or debt.
Equity oriented mutual fund schemes if held for the long-term i.e. in Income-tax Act parlance over 12
months, offer a tax advantage to you, the investor, since Long Term Capital Gain (LTCG) tax is exempt.
But if units of the equity scheme are held for the short-term i.e. in Income-tax Act parlance 12 months
or less, Short Term Capital Gain (STCG) tax is levied @ 15%.

On the other hand, your gains from long term investment in debt mutual funds (i.e. over a period of 1
year) is taxable @ 20% with indexation and 10% without indexation (whichever is lower); while your
short-term capital gain from debt and liquid mutual funds is taxable as per your tax slab.

In case of bank FDs, the interest is taxable as per your tax slab (i.e. as per marginal rate of taxation)
irrespective of the tenure of the bank FD. Thus comparatively, investing in mutual funds is more tax
efficient than bank FDs.

A quick comparison: Mutual funds vs. Bank FDs…

Parameters Mutual Funds Fixed Deposits

Rate of Returns No Assured Returns Fixed Returns

Inflation Adjusted Potential for High Inflation-adjusted Usually Low Inflation-adjusted

Returns Returns Returns

Risk Medium to High Risk Low Risk

Liquidity High liquidity Medium to Low Liquidity

Premature Withdrawal Allowed with Exit Load Allowed with Penalty

Cost of Investment Management Cost No Cost

Tax Status# Favourable Tax Status As Per Tax Slab

(# Taxation details are as per existing tax laws.

The nature of tax will depend based on
the individuals tax status and nature of investments)

Notwithstanding the above, investing in mutual funds offer advantages:

✓Facilitates diversification;
✓The minimum investment amount required is low;
✓Offers economies of scale, translating into better returns for you;
✓Offers innovative modes of investing and withdrawing – Systematic Investment Plans (SIPs),
Systematic Transfer Plans (STPs), Systematic Withdrawal Plans (SWPs), etc.;
✓You can tactically allocate your investible surplus; and
✓Your hard-earned money is professionally managed by professionals who hold years of
experience in financial research and fund management.

How should you invest in mutual funds?

You ought to choose the category of mutual fund schemes (equity and/or debt) and their type wisely,
paying heed to your risk profile, investment time horizon, and the financial goals you’re striving to
achieve; so that your asset allocation is done optimally.

For instance, when you’re averse to risk, the investment horizon is relatively short (less than 3 years)
and financial goals are approaching, a dominant portion of the investible surplus should be parked in
debt instruments, where debt mutual funds can be considered. But here too, tread carefully and take
into cognisance of the interest rate cycle. At present, if you hold a slightly high risk appetite and have
a long time horizon of at least 3 years, not more than 20% of your entire debt portfolio may be
allocated to long-term debt funds via dynamic bond funds (as they are enabled by their investment
mandate to take positions across maturity profile of debt papers).

In case you have a time horizon of less than a year and risk profile doesn’t permit, stay away from
funds with longer maturities.

If you have a short-term investment horizon of 3 to 6 months, you could consider investing in
ultra-short term funds (also known as liquid plus funds). And if you have an extremely short-term time
horizon (of less than 3 months) you would be better-off investing in liquid funds. Don’t forget that
investing in debt funds is not risk-free.

Those of you, who have a very high risk appetite or can afford to take risk, diversified equity oriented
mutual funds, would be suitable. But take enough care to select to best or winning mutual fund
schemes for your portfolio. Focus on mutual fund houses that follow strong investment processes and
systems, and make sure you have a long-term investment horizon of at least 5 years and your
financial goals too, are afar. It would be best to systematically stagger your investments. Those who
are new to equity investing prefer the mutual fund route by opting for balanced funds and large-caps.
Moreover, prefer the SIP mode of investing, which will help you mitigate the risk
better. Thoughtlessly investing or speculating can be hazardous to your wealth and health.