Recurring Deposit or Mutual Fund SIP– Which is Better?
Recurring deposit (RD) is one of the most popular investment option for low risk investors. By enabling investment of smaller amounts at regular intervals, RDs have facilitated regular investment and instilled financial discipline among small savers. However, the growing awareness about mutual funds has led many retail investors to turn towards SIP, especially in debt mutual funds, due to the potential of earning higher returns. Here is a brief comparison between RD and SIP on how they fare against each other:
Recurring deposit is covered under the deposit insurance scheme from the Deposit Insurance and Credit Guarantee Corporation (DICGC). This cover insures your RDs along with your current, savings and fixed deposits of up to Rs. 1 lakh in case of bank failure. Those having deposits with multiple banks are entitled to Rs. 1 lakh cover for each of the bank. However, this cover is only applicable to the deposits opened with Scheduled Banks – banks listed in the Second Schedule of the Reserve Bank of India Act.
Being just a mode to invest in market linked investment, the capital protection on investing through SIPs depends on the type of the fund invested in. The risk of capital erosion is highest in the equity funds, followed by hybrid and debts funds. Among the debt fund types, the risk is the lowest, almost negligible in overnight, liquid and ultra-short duration funds.
RDs guarantee principal repayments and interest income at booked interest rates irrespective of any changes in the card rate during the tenure. For example, if you open an RD of 1-year tenure at 6% p.a., the interest rate will remain same till the end of the tenure irrespective of any changes in the interest rates of the concerned bank in the interim.
Returns from mutual funds depend on the performance of the underlying instruments in the market. However, investing through SIP helps to average your purchase cost during market dips and corrections. As a fixed amount is invested at regular intervals regardless of the NAV or the market level, retail investors automatically end up with more units during falling markets. Opt for SIPs in equity funds for your long term financial goals as equities outperform fixed income instruments by a wide margin over the long term. For short term financial goals, opt for SIPs in short term debt funds such as ultra-short duration, short duration and low duration funds. These funds usually outperform bank fixed deposits while offering higher capital protection than other debt funds and equity funds.
Generally, banks charge a penalty of up to 1% on the pre-mature withdrawal of RDs.
In case of debt mutual funds, only fixed maturity plan restricts redemption while in equities, ELSS do not allow redemption before 3 years of investment. While other fund categories have no restrictions on withdrawal, most charge an exit load of up to 2% on redeeming them before a pre-specified period. However, short term debt funds, such as liquid, ultra-short duration, overnight and most low duration and short duration debt funds do not charge any exit load. Thus, short term debt funds outscore RDs when it comes to unplanned redemption cost. The equity funds too outperform RDs in case of redemption flexibility as most equity funds do not charge exit load after 1 year of investment.
The interest earned from your recurring deposits is added to your total income and taxed in accordance to your tax slab. In case of SIPs, the taxation depends on the mutual fund type and the holding period. In equity funds, gains booked on investments held for less than 1 year attracts Short Term Capital Gains (STCG) Tax of 15%. Gains in excess of Rs 1 lakh booked after 1 year of investment attracts Long Term Capital Gains (LTCG) tax of 10%. Long term capital gains of up to Rs 1 lakh per year is tax free. Additionally, SIP investments in ELSS funds of up to Rs 1.5 lakh per year qualify for tax deduction under Section 80C.
In case of debt funds, the gains made on redeeming the investments within 3 years is treated as short term capital gains and taxed as per your tax slab. The gains realised after 3 years are treated as long-term capital gains and taxed at 20% with indexation benefits. Thus, investing in debt funds through SIP is more tax efficient than RDs for those falling under higher tax brackets with an investment horizon of over 3 years.
RD vs SIP-Which to choose?
Recurring deposits offer guaranteed returns and capital protection through the Deposit Insurance scheme from the Deposit Insurance and Credit Guarantee Corporation (DICGC). This makes RDs a popular option for low risk investors preferring income certainty and high degree of capital protection for all types of financial goals.
Those with higher risk appetite can consider SIPs in mutual funds. Such investors can consider SIP in short term debt funds such as ultra-short duration, short duration and low duration funds for their short-term financial goals. These funds usually outperform FDs and RDs while offering higher degree of capital protection than equity funds.
For long term financial goals, investors should consider SIPs in equity funds as equity as an asset class outperforms other asset classes including fixed income instruments by a wide margin over the long term.
(Originally appeared in ‘The Hindu Business Line’)