PROTECT RETURNS FROM Declining Interest RATES

 





Banks are going to lower their deposit rates. But you can earn higher returns by choosing mutual funds instead

Interest rates are clearly on the way down. The State Bank of India has lowered the in terest rate on savings bank accounts to 3.5%.

Fixed deposit rates are still around 6.25% for most people but are surely headed lower. This is a reduction of about 25% of what investors were earning on their fixed deposits just a couple of years back. Don't be surprised if, in about a year or so, most banks are paying 3.5% on savings accounts and 5-5.5% on fixed deposits.

Since individuals park a big chunk of their money in these two types of savings, the fall in interest rates is a problem. Is there a solution? As it happens, there is. There are mutual fund products that fit the bill perfectly. They not only give you higher returns than these banking products, but also get taxed at a lower rate, making the effective return very attractive. The convenience is still not up to the level of a savings account, although it's pretty close.

The types of mutual funds that make a good substitute for bank accounts are liquid funds, ultra short term funds and short-term funds. These types of funds offer fairly predictable and stable returns and have negligible volatility. Over the past one year, liquid funds have given an average 6.62% returns, ultra-short term fund returns have been 7.45%, and short-term funds have given 8.62%. These are substantially higher than the bank products they can replace in your investment portfolio.

However, there's actually much more to the story. Firstly, most fund house allow you to invest in and redeem liquid funds through mobile apps.Using these mobile apps, you can invest instantly by transferring money from your bank account.More importantly, you can redeem your investment and the money gets transferred to your savings bank account within 5-10 minutes. I have personally tried this and the convenience is magical. To be able to earn interest which is more than one and a half times that of a savings account and yet suffer a liquidity compromise of only a few minutes is a real advance in the tech-enablement of Indian personal finance.

Now let's turn to replacing fixed deposits with ultra-short-term and short-term funds. The former are a good substitute for fixed deposits of up to a year and the latter for longer periods. In the case of these products, the investment can be done through an app or online. In exchange for higher returns, you do have to wait for two business days for redemption. However, the financial benefits are significant.

The benefits go much beyond just the headline return comparison, which is currently about 6.25% vs 8.6%. There's an even bigger difference in posttax returns. The tax difference arises from the fact that fixed deposit returns are classified as interest income while mutual fund returns are classified as capital gains. Tax rules say that you have to pay tax every year for the interest earned that year. If your total interest income from a bank (all accounts and deposits together) exceeds `10,000 in a year, then the bank also deducts 10% TDS.In fact, if the bank does not know your PAN, it will deduct 20%. This means that a part of your return is not available for compounding because it is paid as tax every year.This makes a difference to returns.

There is a further advantage to the mutual fund option if you stay invested for more than three years. If you redeem after three years, then the gains are classified as long-term capital gains and are taxed after indexation. Roughly speaking, you get taxed only on inflation adjusted returns. This advantage is not available to investors in fixed deposits. Applying all these factors, a three-year investment in a shortterm fund will leave you with almost twice the returns as a fixed deposit over the same period, and with excellent liquidity.

If you are willing to forego all chances of redemption for three years, then the type of fund to choose is the so-called fixed maturity plan (FMP). These are likely to give somewhat higher returns. However, since liquidity is generally one of the desirable feature of any investment, the previous three types of funds are a better choice. As interest rates fall, and fixed-income depositors get more and more worried, I would expect the more knowledgeable ones to shift from banking products to these types of mutual funds.

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