Should you break a fixed deposit to buy a debt mutual fund?

by Manshu on January 31, 2013

in Fixed Deposits

I have missed a lot of Suggest a Topic comments in the past month or so and I’m going to try and address all of them in the next few days.

The first one is from Colin that talks about breaking a fixed deposit and getting into a debt mutual fund. Here is the comment for context.

Colin January 9, 2013 at 9:26 pm [edit]

With interest rates falling, the temptation to move into long term debt funds rather than FD for high tax paying citizens is becoming very compelling. How does one evaluate whether breaking an FD and paying penalty with low rate of interest makes better sense than waiting for FD to mature. Given that a part of the interest is taxed at 30%

REPLY

Let me talk about some parameters that I would like to keep in mind while making this decision.

1. Penalty and reduced interest rate: When you break a fixed deposit, you get penalized in two ways:

  • Usually a longer maturity fixed deposit gets a higher interest rate and lower one gets a lower rate, so when you break a 5 year fixed deposit in one year, you will get the reduced rate for that year. So, you have to consider what’s the reduced rate you will get because of this.
  • Then there is a penalty which is usually one percent on that reduced rate so you will get a lower rate on the already reduced rate which is the return you will now get.

2. Tax Rate: Take the above rate of return, and tax it at 30% if you are in that bracket, and see what’s your net return. If you are in the 10% bracket or the 20% bracket then I would say breaking the fixed deposit under any condition may not be a good idea because debt mutual fund returns are also taxed at 10% plus if they are long term and at your regular tax rate if they are short term capital gains.

Doing the above two steps will give you a sense of how much money you will get from your fixed deposit now and you can obviously compare that with what you were likely to get if you don’t break the fixed deposit.

3. What is a reasonable assumption for a debt fund return? This is perhaps the most difficult question because if you have a 5 year fixed deposit and you are breaking it then you should have a good level of confidence that in the next five years your debt mutual funds will outperform your fixed deposit. A look at Moneycontrol page for debt funds tells us that in the last 3 years annualized returns of the best debt funds across every category has been 7 – 10%.   With interest rates coming down there is a lot of interest and expectation that debt funds would do better than this but I don’t know how much better and I certainly wouldn’t be very optimistic that they can do a lot better than this.

These are the three things that I would keep in mind, and I don’t particularly like the idea of breaking an existing fixed deposit to do this but that’s just a personal opinion. It might make sense for some one in the higher tax bracket who has all their money tied up in fixed deposits.

Please leave a comment to let me know what you think.

This post was from the Suggest a Topic page. 

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{ 6 comments… read them below or add one }

Amitesh Kishore January 31, 2013 at 8:29 am

Dear Sir,
For a layman investor the comparison is very good and explanation is better but the part of this opportunity is already gone and not many will benefit from this already peaked out market. Wish your article would hit us six months ago.
Regards.

Reply

Manshu January 31, 2013 at 8:50 am

That’s a good point, debt funds have run up a fair bit in the past six months. I must however admit that I didn’t think of investing in debt funds six months ago to take advantage of the run up and that’s how I didn’t write about it.

Reply

anna January 31, 2013 at 10:12 am

Dear Sir,
Good article !!!
As U said , even I am trying to get into Debt funds now..As Mr. Amitesh says that the opurtunity is partly gone, I believe its only partly gone ( Please correct me if i am wrong)…we definitely expect more rate cut in May if not in March- so is entering debt fund even today a good option???

2) Which is a better option to park money with a 3 yr horizon??- Dynamic Bond fund or FMP’s of suitable tenure??

3) Is it worthwhile parking a very small portion in Gilt Funds if we can withstand the volatility?? Or rather its better to go with the fund manager in Dynamic Fund??

Reply

Manshu February 1, 2013 at 6:08 pm

These are all difficult questions Anna, and I’m afraid I don’t feel confident enough to answer any of these.

Reply

ankurm January 31, 2013 at 1:38 pm

It may not be advisable to break FDs, unless some high priority/value expenditure or investment (like purchase of house) is required. However, if FD was only recently opened, the loss is very minimal, and can be liquidated.

Reply

Manshu February 1, 2013 at 6:05 pm

Yeah, I think that makes sense to me too.

Reply

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