Fixed deposits vs. mutual funds - what's more suitable for your money?

Posted On: 20 June 2023

(ELSS) have a mandatory lock-in period. While both offer liquidity to some extent, reviewing the specific terms is essential Fixed deposits (FDs) have long been a popular choice for people looking to save and invest their money. FDs have earned a reputation as a safe and time-tested investment avenue. However, in today's dynamic financial landscape, it is essential to reassess whether FDs remain the optimal investment option. Are there better alternatives available? Can mutual funds provide a more efficient path to achieve our financial goals?
In this article, we will have a look at these questions to gain a deeper understanding of where to invest your hard-earned money. So, read on for insights and guidance on making informed investment decisions.

Table of contents

What are fixed deposits?
What are mutual funds?
Difference between FDs and Mutual Funds
Benefits of mutual funds
Benefits of fixed deposits
How to invest in a Mutual Fund vs FD?
Fixed deposit or mutual fund - which is better?

What are fixed deposits?

A fixed deposit is an investment option that allows individuals to invest a specific amount of money with a bank or financial institution for a predetermined period. During this period, the depositor earns interest at a fixed rate, which is generally higher than regular savings accounts. At the maturity of the fixed deposit, the principal amount is returned to the investor along with the accumulated interest. Moreover, there is also an option of periodic payout in fixed deposits.

One of the key advantages of fixed deposits is guaranteed returns. Unlike other investment options that are influenced by market fluctuations, the interest earned on fixed deposits remains constant throughout the tenure. Thus, fixed deposits are considered a relatively safe investment option due to their stability and low risk.
Fixed deposits provide individuals with a predictable income stream and can be a suitable for those seeking a secure and conservative approach to grow their savings.
It is important to note that fixed deposits may offer lower returns compared to other investment avenues such as mutual funds or stocks. Moreover, the returns from FDs may fail to outrun the march of inflation.

What are mutual funds?

A mutual fund is an investment vehicle managed by a skilled fund manager. It operates as a trust that pools money from numerous investors who have a common investment goal. The collected funds are then invested in a diversified portfolio of assets such as stocks, bonds, money market instruments, and other securities. The returns generated by these investments, after deducting expenses and fees, are distributed proportionately among the investors. This distribution is calculated based on the mutual fund's "Net Asset Value" or NAV.

Difference between FDs and Mutual Funds

Safety: Fixed Deposits (FDs) are generally considered very safe, subject to the financial strength of the bank where the deposit is made. On the other hand, mutual funds are subject to market risks. The level of risk varies among different types of mutual fund schemes, and investors should choose funds basis their risk appetite.

Liquidity: FDs have moderate to high liquidity, but penalties may apply for premature withdrawals. In contrast, open-ended mutual funds offer high liquidity, allowing investors to redeem their investment at any time. However, exit loads may be applicable if withdrawals are made within a certain period from the date of investment.

Returns: FDs provide assured returns at a predetermined interest rate. Mutual funds, on the other hand, offer market-linked returns. The historical track record of the top-performing funds across various categories shows strong returns potential. However, it must be noted that the past performance does not guarantee future returns.

axation: The interest earned on FDs is taxed as per the income tax slab of the investors. In the case of mutual funds, taxes on Income Distribution cum Withdrawal and capital gains taxes are levied. Taxation on mutual funds also depends on the type of mutual funds.

Investor interest protection: FDs are regulated by the Reserve Bank of India (RBI) to ensure investor protection. Mutual funds, on the other hand, are regulated by the Securities and Exchange Board of India (SEBI), which sets guidelines and regulations to safeguard the interests of mutual fund investors.

Portfolio diversification: Mutual funds provide more options for portfolio diversification than fixed deposits provide. You can choose to diversify your portfolio based on your financial objectives and risk tolerance rather than placing all your eggs in one basket. For those who are more willing to take a greater amount of risk, there are credit risk funds that invest in bonds with lower credit ratings but have the potential to provide returns, or dynamic bond funds where a fund manager can change your portfolio in response to market developments.

Benefits of mutual funds

They provide professional management by experienced fund managers, saving investors’ time and effort.
They offer risk diversification by investing in a wide range of securities, reducing the impact of market volatility.
Mutual funds are affordable, allowing individuals to invest with small amounts with the help of Systematic Investment Plan(SIP).
Mutual funds have the potential to deliver inflation-beating returns in long term. Investing in mutual funds can take you a step closer to your financial goals.

Benefits of fixed deposits

They provide a secure and stable investment option, as the principal amount is guaranteed and unaffected by market fluctuations.
FDs also offer fixed and assured returns at a predetermined interest rate, allowing investors to plan and estimate their earnings.
FDs are easy to understand and manage, making them a good option for individuals who prefer simplicity in their investments.

How to invest in a Mutual Fund vs FD?

Mutual Funds:

Choose a fund and platform: Select a mutual fund that aligns with your financial goals, risk tolerance, and investment horizon. Consider factors like the fund's past performance, expense ratio, and fund manager. Then, choose a platform to invest. You can invest directly through the Asset Management Company (AMC) or through online platforms, brokers, or mutual fund distributors.

Complete KYC: Before investing, you need to complete your Know Your Customer (KYC) process. This involves verifying your identity and address. You can do this online through various platforms or offline through designated KYC registration agencies (KRAs).

Invest: Once your KYC is complete and you've chosen a fund and platform, you can start investing. You can invest a lump sum or opt for a Systematic Investment Plan (SIP), which involves investing a fixed amount regularly. Most platforms offer online payment options for convenient investing.

Fixed deposit:

Choose institution & scheme: Select a bank, post office, or NBFC and an FD scheme with a suitable tenure and interest rate.

Open an account: Open an FD account online or offline, providing necessary documents.

Make the deposit: Deposit funds via net banking, cheque, or other accepted methods.

Fixed deposit or mutual fund - which is better?

Deciding between a fixed deposit (FD) and a mutual fund depends on individual financial goals, risk tolerance, and investment horizon. There is no universal answer, as each investment option has its own advantages and limitations.

Potential returns: FDs provide relatively steady returns at a fixed interest rate. However, these returns may not always keep up with inflation over time.

Risk: FDs are considered relatively low risk and are protected by deposit insurance up to a specified limit.

Liquidity: FDs typically have a lock-in period, and early withdrawals may lead to penalties.

Mutual funds:

Potential returns: Mutual funds, particularly equity-based funds, offer the potential for higher returns than FDs but involve higher risk. Debt funds carry lower risk and lower potential returns compared to equity funds.

Risk: Mutual funds are subject to market fluctuations, which affect investment value. Equity funds are considered high risk, while debt funds have lower risk but still experience some market volatility. Hybrid funds that invest in both equity and debt also require a high risk appetite.

Liquidity: Most mutual funds provide relatively high liquidity, allowing investors to redeem their units on business days, though some may have exit loads.

Conclusion

While fixed deposits offer assured returns, mutual funds come with market risks. However, in a declining interest rate environment, mutual funds can be a suitable option if you assess your risk tolerance before taking the plunge. Therefore, it's important to consider your financial goals and risk appetite before making investment choices. Now that you have a better understanding of Fixed deposits vs mutual funds, ensure that you take into consideration all the aspects of FD vs MF before making the final decision.

FAQs:

What is the difference between Fixed Deposits (FDs) and Mutual Funds?

Fixed Deposits are investment options offered by banks, wherein you deposit a specific amount of money for a fixed period at a fixed interest rate. At the end of the tenure, you receive the principal amount plus the interest earned. Mutual funds pool money from multiple investors to invest in a diversified portfolio of securities. Mutual funds are managed by professional fund managers and aim to generate returns based on the performance of the underlying investments.

Which investment option is more suitable for long-term goals?

For long-term goals like retirement planning or wealth accumulation, mutual funds have the potential for higher returns. FDs, with their fixed interest rates, may not provide the same growth potential over an extended investment horizon. You must carefully evaluate your investment objective before making the final decision.

How does risk differ between FDs and Mutual Funds?

FDs are generally considered low-risk investments as they offer fixed returns. Mutual funds carry market-related risks as their returns depend on the performance of the underlying securities and are subject to market fluctuations.

Which investment option offers better tax benefits: Fixed Deposits or Mutual Funds?

Neither fixed deposits (FDs) nor mutual funds provide significant tax benefits in their standard form. Interest earned on FDs is taxed as per the investor’s income tax slab. Previously, long-term capital gains on debt funds were taxed at 20% after indexation, but now, gains from debt mutual funds, regardless of the holding period, are taxed at the applicable income tax slab. Equity mutual funds have a different tax structure. Therefore, neither FDs nor debt funds have a distinct tax advantage over the other.

Can I withdraw my money before maturity in Fixed Deposits and Mutual Funds?

Yes, early withdrawals are possible for both FDs and mutual funds, but conditions apply. Premature FD withdrawals usually result in penalties, typically in the form of reduced interest. Mutual fund redemptions are generally easier, but exit loads may apply based on the fund and holding period. Additionally, Equity Linked Savings Schemes (ELSS) have a mandatory lock-in period. While both offer liquidity to some extent, reviewing the specific terms is essential.

Which is better for beginners: Fixed Deposits or Mutual Funds?

Fixed deposits (FDs) are often considered more straightforward for beginners, as they provide a fixed return over a specific period, offering relative predictability. Mutual funds, particularly equity funds, can be more volatile and require some understanding of market trends. However, debt mutual funds may be suitable for beginners seeking some exposure to market-linked returns with relatively lower risk compared to equity funds.

How do inflation and interest rate changes affect Fixed Deposits and Mutual Funds?

Inflation reduces the purchasing power of money over time. If an FD’s interest rate is lower than inflation, the real return (adjusted for inflation) becomes negative. When interest rates rise, new FDs become more attractive, but existing ones continue at their original rate. Debt mutual funds may see a decline in Net Asset Value (NAV) with rising interest rates. Equity mutual funds, while subject to market fluctuations, have the potential to generate returns that outpace inflation over the long term.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.