Despite a few hiccups along the way, it's more than likely that India is heading for lower interest rates for years, perhaps for decades. In fact, if one steps out of the ivory tower of economists and into the real life of savers, a huge amount of damage is already done. 2.5 - 3.5 per cent on savings banks and 5-7 per cent on various deposits are going to be the normal range now onwards.
Most Indian savers--including retirees who need income--are heavy users of bank fixed deposits. Their earnings are down by 25 per cent or more in the last three years. 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 an effectively lower tax outgo, making the effective return very attractive. In fact, compared to fixed deposits, the liquidity and the convenience are also superior, especially if you deal through the special apps that many funds have released for the purpose.
SEBI's recent reorganisation of fund categories has somewhat changed the lie of the land, so the types of mutual funds that work well as substitutes for bank accounts are liquid funds and ultra-short duration funds. These funds have predictable and stable returns that have negligible volatility. The precise definitions that SEBI has now enforced has made them even more so. Over the last one year, liquid fund returns have been an average of 6.85 per cent, ultra-short duration fund returns have been 6.47 percent.
While these compare well to the deposit products they can replace, the real kickers are the convenience and the tax factors. 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. More to the point, you can redeem the investments and the money gets transferred to your savings account within five to ten minutes. To be able to earn interest which is 1.5X that of savings accounts and yet have a liquidity compromise of only a few minutes.
The benefits of using funds go much beyond a simple comparison of returns. The different taxation structure means there's a bigger difference in post-tax returns. The tax difference arises from the fact that returns from fixed deposit are classified as interest income while mutual fund returns are classified as 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.
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. Essentially, 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.
Earlier, this kind of fine-tuning could be expected only for a handful of knowledgable and involved investors. However, with low interest rates, the payoff is huge, and a lot of us could benefit substantially from shifting away from deposit-type products and move towards mutual funds.