Are you looking for alternatives to fixed deposits in India?
I don’t blame you.
The current fixed deposits FD rates in India are not great – even for the banks best for fixed deposits earlier.
And as these banks continue to cut down fixed deposit interest rates, it’s only natural for savers to question whether it makes sense to keep money in bank FDs or not.
So if you are looking to earn returns that are higher than bank FDs or you are looking for alternatives to fixed deposits in India… then what are your possible options?
One good alternative is debt funds.
Please… I am not saying FDs are bad. I am just saying that once you go through any debt fund vs fixed deposit comparison, you too would feel that it’s a reasonably good option.
But the actual answer to your question (i.e. good alternatives to fixed deposits) depends on your investment (or savings) horizon, i.e. for how long you don’t need the money?
Some possible investment horizons are:
- Less than 1 year
- 1-3 years
- 3-5 years
- 5-10 years
- 10+ years
There is absolutely no point in using bank FDs for all the above-specified periods. Though it may still be suitable for some.
Apart from low fixed returns, one of the biggest issues with fixed deposits is their unfriendly tax treatment (read more about fixed deposit taxation in India). These two are the main reason why you should not invest in fixed deposits for the long term. If you do, you will screw your wealth creation plans!
Let’s see how…
If you put Rs 1 lac in FD giving 6%, then theoretically you earn Rs 6000 as interest. Right?
But if you fall in 20% bracket, your effective return will be Rs 4800 (Rs 6000 – Rs 1200, i.e. 20% tax on Rs 6000). That means that you earn only 4.8%.
Note – If you are using any of the fixed deposit calculators that are available online, make sure that the FD calculators show maturity amount after taking into account the impact of taxes.
If you compare these post-tax interest rates with the average inflation numbers in India, you would end up earning almost nothing or in many high-inflation scenarios, you end up losing money for just keeping it in banks! 🙂
So the real post-tax interest rate on fixed deposits is much lower than what banks advertise or tell you.
And please… don’t be fooled by the Annual Yields of fixed deposits that banks and relationship managers keep shouting about.
Annual Interest is different from Annual Yield. Suppose you put in Rs 1 lakh in bank FD giving 8% interest per year. Now at the end of 3 years (ignoring taxes), the value of your FD will be as follows:
- Rs 1,08,000 at the end of 1st year = Rs1.08 lakh
- Rs 1,16,640 at the end of 2nd year = Rs 1.17 lakh
- Rs 1,25,971 at the end of 3rd year = Rs 1.26 lakh
The annual interest rate is a constant 8%. But what about the annual yield?
It is calculated as follows:
- Rs 1.08 lakh / Rs 1 lakh = 8% à 8%/1 = 8%
- Rs 1.17 lakh / Rs 1 lakh = 17% à 17%/2 = 8.5%
- Rs 1.26 lakh / Rs 1 lakh = 26% à 26%/3 = 8.67%
This is how maths for annual yield works. But it’s not useful. You still get only 8% per annum. Right? But banks will try to mislead you by telling ‘a 3-year FD with an annualized yield of 8.67%’ instead of 8% annual interest. And if the interest rate is higher, like say 10%, then the annualized yield will be higher.
Now take a guess which one of the two options below looks more attractive:
- 3-year FD giving 10% a year, OR
- 3-year FD with an annual yield of 11.03%.
Both are same 🙂 …but you know what looks more attractive.
Let’s come back to the investment horizons now…
Where should you put your money when it is not needed for:
- Less than 1 year
- 1-3 years
- 3-5 years
- 5-10 years
- 10+ years
That is to say:
- Investing for 1 year: Put it in FD. Plain and simple.
- Investing for 1-3 years: Use a combination of FDs and debt funds. Read how to pick good debt funds. If you need money in parts or/and you don’t know exactly when you need it in the 1-3 year period, then put more in debt funds.
- Investing for 3-5 years: Put it in debt funds. If aggressive, put a small percentage in equity funds too depending on your risk appetite.
- Investing for 5-10 years: Put 50% in equity (more if you are aggressive). Rest in good debt funds.
- Investing for 10+ years: Put 60-70% in equity. Rest in debt funds or other debt instruments like PPF (EPF, etc.).
Note – These are general suggestions. Depending on the individual’s actual financial need and situation, the advice might differ.
There are several different debt fund categories in India. Debt funds offer potentially better post-tax returns than fixed deposits (read about debt fund taxation if you want to). But they are not risk-free. So make sure you understand which debt fund categories are suitable for you.
You already know why every sensible person recommends ‘more’ equity for long term investment horizons. Just one example proving this.
But what about the debt fund? What is it that makes debt funds better investment alternatives to fixed deposits when investing for more than a couple of years?
Why Debt Funds are good alternatives to bank FDs?
First of all, the recent historical returns offered by debt funds have been higher than bank FDs.
So even though investors take credit and interest rate risk when investing in debt funds, more often than not, they are well compensated by higher returns of debt funds. In fact, the top debt mutual funds at times give equity funds a run for their money (But it’s wrong to compare debt mutual funds vs equity mutual funds as these represent two separate asset classes)
Of course you need to pick the right debt fund in order get the required returns (Not all debt mutual fund offer FD like returns). I suggest you also read what debt funds are NOT? (my quote in Morningstar)
The interest earned from a fixed deposit is practically guaranteed. But the capital gains (or returns) from debt funds are not. But even then, debt funds are considerably safe if picked correctly (my quote in Morningstar).
Another big reason is that the debt funds are far more tax-efficient than bank FDs. So when it comes to FD vs Debt fund taxation, the latter wins easily.
If debt funds are held for more than 3 years, the capital gains are taxed at 20% after indexation. And for all practical purposes, there is very little tax outgo after indexation benefits. So it works very well for those who are in higher tax brackets.
In debt funds, one only has to pay capital gains tax as and when the withdrawal is made. In FDs, tax payment ideally should happen every year.
Here is how indexation benefit of debt fund reduces taxes (with examples).
There are some other benefits too.
Generally, there are no lock-ins in debt funds. Being completely liquid, investors can withdraw the full amount out of debt funds any time; that too without having to worry about things like premature withdrawal penalty – something that is applicable in bank fixed deposits. Early withdrawal in FD attracts premature withdrawal penalty.
Debt funds also allow partial withdrawals – this option is generally not available in FDs.
Now let me just simplify it for you.
If you want to park money for just one year, just stick with bank FDs (or you can pick a debt fund too). However, if you are putting money in for 3-5 years, debt funds are reasonably good alternatives to fixed deposits in India.
Don’t get too bogged down with the FD vs debt fund debate or with comparisons of FD vs Mutual Fund kinds. Both FD and debt funds can have a place in your financial life. You just need to know which ones are suitable for which goal of yours.
And since all debt funds are not the same, it’s always advisable to understand what you are getting into. Or to put it very simply, know which debt funds are actually good for your needs.
I know there is something remarkably clean, simple and honest about FDs. J And there is absolutely no doubt that fixed deposits have been the preferred savings option for a significantly large number of Indians.
But if you are taking intelligent investment decisions, an FD may not be suitable for all situations. Debt fund is a good choice that you should consider when saving money for up to 5 years. And for longer-term financial goals, a higher proportion of equity is necessary. Do not use fixed deposits for long term wealth creation. You will not create any wealth that way. 🙂
So now that you know all about the major differences between debt funds and fixed deposits, will you invest in Bank Fixed Deposits or Debt Mutual Funds?
You can best answer that question. 🙂
It is true that when it comes to interest rates of fixed deposits, they do offer assured returns. But it is also true that debt funds offer higher post-tax returns. That’s not all. When it comes to FD vs debt fund taxation and flexibility of withdrawal, once again it’s the debt funds that come up on top as a suitable alternative to fixed deposits in India.
But please don’t think that I am asking you to get rid of all your fixed deposits immediately. 🙂
If you have been parking money in FD for years and the concept of debt funds is new to you, I suggest you take it slowly.
Gradually understand about this great debt product that offers higher returns than FDs and higher flexibility. And once you have become comfortable with it, only then start making the switch to debt funds as required by your investment plan.