Debt Fund vs FD: Know The Difference

As the investment landscape continues to evolve, individuals seeking to safeguard their hard-earned savings have always found solace in fixed deposits. With their reputation as a reliable option for low-risk investments, fixed deposits have garnered widespread popularity among investors. Offering guaranteed returns and reasonable rates, they have long been the go-to choice for risk-averse individuals in the face of a constantly changing financial environment.

Unlike other investment options that are subject to fluctuating interest rates, fixed deposits provide a sense of stability by offering interest at a fixed rate. However, with the growing awareness of alternative investment avenues, particularly debt mutual funds, it becomes crucial to delve deeper and understand which option best suits your financial goals. In this blog, we will explore the key differences between debt funds and fixed deposits, equipping you with the knowledge to make an informed investment decision.

Understanding Debt Funds and Fixed Deposits

Fixed deposits, commonly referred to as term deposits, represent a popular savings avenue provided by banks and other financial institutions. These accounts are characterized by a predetermined interest rate and maturity date, with the deposit being guaranteed by the institution.

Designed to be low-risk investments, fixed deposits cater to individuals seeking a stable return on their savings. By opting for this option, one can confidently allocate their funds with the assurance of a fixed yield.

In contrast, debt mutual funds operate as mutual funds that primarily invest in fixed-income securities such as bonds and debentures. Unlike fixed deposits, these funds offer the potential for higher returns; however, they come with an inherent element of risk. The performance of debt funds is influenced by market fluctuations, which means that the returns are not fixed.

Debt mutual funds are particularly appealing to individuals who are willing to accept a slightly higher level of risk in exchange for the potential of greater returns compared to fixed deposits. By diversifying their investments across a range of fixed-income securities, investors can tap into market opportunities and potentially enhance their earnings.

Understand in detail – What is a Fixed Deposit Account?

Debt Funds vs Fixed Deposits

Criteria Debt Funds Fixed Deposits
Interest Rates Typically offers interest rates ranging from 7% to 9% Generally provides interest rates in the range of 6% to 8%
Market Dependency Performance linked to market fluctuations, influenced by bonds, etc. Not affected by stock market volatility, independent of the market
Risk Factor Low to moderate risk due to market fluctuations Offers guaranteed returns with minimal risk
Dividend Option Dividend option available No dividend option available
Liquidity High liquidity, can be redeemed anytime with possible exit load Low liquidity, early withdrawal with penalty charge
Investment Option Offers both SIP (Systematic Investment Plan) and lump-sum options Only allows lump-sum investment
Early Withdrawal Allowed with or without exit load, depending on the fund type Penalty imposed for premature withdrawals
Charges Incurs expenditure ratios ranging from 0.2% to 2.25% No management costs or fees imposed by banks
Investment Expense Nominal expense ratio charged for managing the funds No additional investment expenses


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FD vs Debt Fund: Taxation

For debt funds, the taxation of short-term gains, realized within a period of less than three years, follows the prevailing income tax slab rates. However, when it comes to long-term gains, held for a period exceeding three years, the taxable rate stands at a favorable 20% with the added advantage of indexation. On the other hand, regarding fixed deposit returns, the gains will be subject to taxation in accordance with your applicable income tax slabs.

Debt Fund vs FD: Inflation Adaptability

It is widely recognized that inflation has a detrimental effect on savings by eroding the value of currency. However, there exists an alternative avenue that holds promise in keeping pace with inflation: debt mutual funds. While they carry certain risks, these funds have the potential to offer returns that align with the rising tide of inflation. To illustrate, let’s consider an example where you have invested in a fixed deposit (FD) with a 6% interest rate, while the inflation rate stands at 5%. In this scenario, the adjusted return would amount to a mere 1%. Conversely, debt funds have the potential to deliver comparatively higher returns, making them an appealing option for those seeking to combat the effects of inflation on their investments.

Summing up With an Illustration

Particulars Debt Funds Fixed Deposits
Invested Capital (Year of purchase – 2015) ₹2,00,000 ₹2,00,000
Returns 7% 7%
Holding period 3 years 3 years
Capital worth at the end of tenure ₹2,45,000 ₹2,45,000
Inflation Adjustment available Adjustment not available
Indexed Cost of Acquisition (Year of sale-2019) ₹2,20,472
Taxed Amount ₹24,528 ₹45,000
Tax to be paid (assuming highest tax bracket of 30%) ₹4,906 (Tax rate applicable is 20%) ₹13,500
Returns after tax ₹40,094 ₹31,500


Final Thoughts

In this blog, we have taken a look into the contrasting characteristics of Debt Funds versus Fixed Deposits (FD) across various aspects. If your primary concern revolves around securing your capital and ensuring a guaranteed return, then FD emerges as the preferred investment choice. However, by allocating a portion of your fixed income assets to debt mutual funds, you open up the potential for superior risk-adjusted returns, along with the added advantage of tax benefits. This serves as a significant differentiating factor when comparing Debt Funds and FD. Ultimately, your investment decision should be guided by your individual financial goals and risk appetite.