For risk-averse investors who want fixed returns, there are two options: bank fixed deposits and debt funds. While both offer fixed returns and are relatively risk-free, especially when compared to equity investments, there are significant differences between the two.
- In fixed deposits, there’s not all that much variety. You can invest in fixed deposits at the post office or at your bank. The only difference is in the interest rates that different banks offer. Debt funds offer much more variety there are funds that invest in government bonds, PSUs, money market, corporate debentures, a mix of equity and debt, and so on. The risk and returns are different for each type of fund.
- Fixed deposits are for a fixed period, and could range from a week to five years. Debt funds are open-ended and have no fixed tenure. You can hold them as long as you like.
- Debt funds are more liquid than fixed deposits since we can redeem them at any point. In Fixed Deposits, you can make premature withdrawals, but you may get a lower interest rate on the withdrawn amount.
- An important difference between the two is interest rate risk. In a fixed deposit, the interest rate is fixed for the tenure of the deposit, regardless of changes in overall rates. In a debt fund, returns could change depending on the movement of interest rates.
- We tax fixed deposits and debt funds differently. We need to add interest income from fixed deposits to our taxable income and pay income tax according to that income. With debt funds, you have to pay capital gains tax. Generally, debt funds have offered better returns than fixed deposits in the past. From the tax point of view, debt funds could be a better choice, especially if you hold them over the long term.