Home / Money / Personal Finance /  Why rising interest rates don't make FDs attractive

With the Reserve Bank of India (RBI) raising the repo rate by 1.40 percentage points over three policy reviews, interest rates on fixed deposits (FDs) have inched up in the last few months. The rates of 3-year and 5-year tenure FDs offered by major banks like ICICI, HDFC and SBI are in the range of 5.5-6.1%, up from 5-5.3% before the rate hikes. Rates offered by small banks and non-bank finance companies (NBFCs) are higher at 6.65-7.95%. Senior citizens get an even sweeter deal in the form of an additional 0.25%-0.5% interest.

While the rising rates have brought some cheer to those investing in FDs, the prevailing high inflation is a dampener. Retail inflation in July was pegged at 6.71% and the six-month average inflation rate stands at 6.92% currently. So, an FD that offers an interest rate below the average annual inflation is actually losing money.

That’s not all. Interest earned from FDs is fully taxable, which further eats into the net return you earn on them. Those in the higher tax slabs especially feel the pinch as the final return on their investment comes down by 100-130 basis points (bps) after factoring in the tax impact (see table).

In fact, high inflation combined with taxation of interest on FDs can even turn the real return negative. Financial planners recommend that people should consider other fixed-income investment options and low-risk debt products that are tax-efficient and can deliver better returns compared to FDs.

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Better alternatives

Taxation of interest income on FDs, National Savings Certificate (NSC) and RBI savings bonds is the same but the latter two score over FDs for various reasons. The interest rate on NSC is 6.8%, while RBI bonds earn 7.15%. Currently, FDs with comparable returns are being offered by either small finance banks or non-banking finance companies (see table). NSCs and RBI bonds come with sovereign guarantee, whereas corporate FDs carry default risks. NSCs help optimize tax as interest on them is added at the end of the year, which can be claimed as a deduction under the 1.5 lakh limit of section 80C. On the flipside, TDS rules on cumulative FDs not only result in loss of capital (TDS amount) but also the compound interest that the TDS amount would have earned during its remaining tenure.

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“Investors who do not want to lock-in their investments for longer tenure of 5-7 years can look at FDs but should not blindly chase high returns," said Amit Suri, a financial planner and mutual fund distributor. Investors must check the credibility of the NBFC or small finance bank by checking the credit ratings. Note that FDs offered by NBFCs are not insured by the government.

For better tax efficiency, non-salaried individuals can also look at the Public Provident Fund (PPF). Note that interest on PF is exempt from tax only on contributions up to 2.5 lakh. Interest rate on PPF is 7.1% currently, which is higher than most large bank’s FDs.

Salaried individuals have the option to earn a high interest of 8.1% through Voluntary Provident Fund (VPF) if, after the mandatory contribution of 12% of basic salary, there is scope to invest more up to the 2.5 lakh tax-free threshold.

Debt MFs a winner

Debt MFs are a better investment option over FDs for low-risk investors from taxation, returns and flexibility perspective. Vijai Mantri, co-founder and Chief Mentor, Jeevantika, said the hike in FD rates is not at the same pace as increase in bond rates, which has been captured by debt MFs more efficiently. “Since February 2022— 1, 3, 12, 36 and 60-month market linked securities’ yields went up by 150 to 200 bps and consequently, yield-to-market of debt MFs have also moved up substantially. But FD rates stubbornly remained same or are now inching up only marginally," he said.

On the tax front, debt funds benefit from indexation on long-term capital gains, which are taxed at 20%. Indexation increases the purchase price of MF units as per the inflation during the holding year, which reduces the capital gains and the subsequent tax liability. “Past data shows that when debt MFs delivered higher return, inflation was also high and so was the CII (cost inflation index). The vice versa is also true. So, in worst case scenarios, taxpayers have effectively paid 11% tax on debt MFs and in best case scenarios, they haven’t paid any tax due to indexation benefit," Mantri said.

Unlike FDs, debt funds offer flexibility as you can make partial withdrawals. An FD can’t be broken in parts and premature termination attracts penalty in the form of lower interest payout.

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