Debt mutual funds or bank FDs: What’s the smarter choice when interest rates fall?

When interest rates start coming down, most savers wonder what to do with their money. Should they lock it in a bank Fixed Deposit (FD) or go for debt mutual funds? Both options are considered suitable and safe for conservative investors. But they work differently.

Bank FDs provide assured returns, while debt funds are linked to the market and can offer slightly better growth when rates drop. Before deciding, it is essential to know how each one behaves in a falling interest rate cycle. Let’s simplify the choice for you.

Debt mutual funds vs. bank FDs: Key differences

Here is how debt funds and bank FDs vary, so you can decide which works well for your financial goals.

• Returns

The biggest difference lies in returns. With bank FDs, the rate is fixed at the time of investment. Even if market rates drop further, your return stays the same till maturity.

In contrast, debt funds have the potential to yield higher returns when interest rates fall, since bond prices rise in such periods. This makes debt funds relatively enticing in a declining rate environment.

• Liquidity

Bank FDs come with certain restrictions when it comes to liquidity. While premature withdrawals are possible, they usually attract penalty charges and lower interest payouts.

Debt mutual funds, on the other hand, are more liquid. You can redeem your investment anytime, and the money is typically credited within one to three working days. This flexibility makes them more suitable if you want easier access to your funds.

• Taxation

For investments on or post April 1, 2023, all gains from debt funds are taxed according to your income tax slab, with no indexation or long-term capital gains benefit, making them the same as FDs.

For investments before April 1, 2023, holdings over 36 months still enjoy 20% tax with indexation, while shorter holdings are taxed at slab rates. This makes older debt fund investments more tax-efficient than FDs.

• Risk factor

Safety is the strongest benefit of bank FDs. They are virtually risk-free since returns are assured and backed by the issuing bank, subject to deposit insurance limits.

Debt mutual funds, while usually safer than equity funds, do carry some risks, such as market risk owing to fluctuating interest rates and credit risk if a bond issuer defaults. That said, these risks are moderate, and careful fund selection can minimise them.

• Flexibility and tools

Bank FDs offer limited flexibility. You select the tenure, say one year, three years, or five years, and stay invested till maturity unless you break it early with penalties.

Debt mutual funds, in contrast, offer a wide variety of choices such as liquid funds, short-duration funds, and corporate bond funds. Investors can also use simple tools like an online mutual fund returns calculator to figure out potential outcomes and plan better.

Conclusion

Both bank FDs and debt mutual funds have their place in a portfolio. If you prefer safety, predictability, and guaranteed returns without worrying about market movements, bank FDs are the right fit.

But if you are willing to take a little risk for the chance of better returns, especially when interest rates are falling, debt mutual funds could be a smarter choice. Having a balanced approach, i.e., parking some money in FDs for security while investing in debt mutual funds for growth, can help you make the most of both options.

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