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Save your returns from falling interest rates

Banks are going to lower and lower interest rates. Can you earn more by choosing mutual funds instead?

Save your returns from falling interest rates

Interests rate are clearly on the way down. The State Bank of India has lowered the interest rate on savings bank accounts to 3.5 per cent. Fixed deposit rates are yet in the region of 5.75 to 6.25 percent for most people but are surely headed lower. Don't be surprised if, in about a year or so, most banks are paying 3.5 percent on savings accounts and 5 to 5.5 percent on fixed deposits.

Since most money of individuals are parked in these two types of savings, this is a problem. This is a reduction of about 25% of what people were earning on their fixed deposits just a couple of years back. 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 are also liable for less tax, 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 have fairly predictable and stable returns that have negligible volatility. Over the last one year, liquid fund returns have been an average of 6.62 per cent, ultra-short term fund returns have been 7.45 percent, and short-term funds 8.62 percent. These are substantially higher than the bank products they can replace.

However, there's actually much more to the story. Firstly, liquid funds can be invested in and redeemed through a smartphone-based app for many fund companies. Through these apps, you can invest instantly by transferring money from your bank accounts. Far more importantly, you can redeem your investment and the money gets transferred to your savings account within five to ten 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 FDs 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 large.

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 post-tax returns. The tax difference arises from the fact that fixed deposit returns are classified as interest income while mutual fund returns are classified capital gains. Under interest income, you have to pay tax every year for the what you earned that year. If your total interest income from a bank (all accounts and deposits together) exceed Rs 10,000 then the bank also deducts TDS at 10%. 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 taken out and 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. You can google the exact method, but roughly speaking, you get taxed only on inflation-adjusted returns. Again, this does not happen with FDs. Applying all these factors, a three year investment in a short-term fund will leave you with almost twice the returns as an FD 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 away from banking products and towards these types of funds.