Fixed Deposits are the traditional investment choice for most Indian households. As per RBI research released in June 2020, 53% of average household financial assets are invested in Bank FDs (as on March 2020). Though mutual funds have a long history in India with the setting up of Unit Trust of India in 1963, popularity of mutual funds among retail investors have grown only in the last 20 – 25 years. As per AMFI data, AUM of mutual funds in India has grown at CAGR of nearly 17% over the last 20 years. Despite the rapid growth, RBI research suggests that mutual funds comprise only 7% of household savings. We will compare FD vs mutual funds so that investors can make informed decisions on whether to invest in FD or mutual funds.

What are Fixed Deposits?

As the name suggests, FDs offer fixed interest rates to investors for fixed tenures. FD tenures can range from 7 days to 10 years. Bank FD interest is compounded, i.e. you get interest on accrued interest. For example, let us assume a bank pays 6% interest (compounding annually) for 3 year FD. If you deposit Rs 100, after 1 year your account will have Rs 106. In year 2, you will get 6% interest on principal plus interest, i.e. 6% on Rs 106 or Rs 6.4. The additional 40 paisa is due to compounding.

A cause of concern especially for senior citizens who invest their savings primarily in FDs is the declining interest rates. FD interest rate has seen secular decline over the past 25 years (see the chart below). With RBI cutting interest rates aggressively in the wake of COVID-19 outbreak, banks have also reduced FD interest rates. On a post-tax basis, FD interest rates are now barely able to beat inflation. FD interest is taxed as per income tax slab of depositors. Since the FD interest rate is fixed over the FD tenure, there is no indexation benefit in taxation if FD vs mutual fund comparison is done. Therefore, there is no protection from inflation, especially when FD interest rates are so low.