Fixed deposit rates may fall. Should you look elsewhere to park your funds?

As the repo rate cut affects FD interest rates, investors must carefully weigh the pros and cons of locking in current FD rates versus exploring other investment options like debt funds.

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Following the Reserve Bank of India's 0.25% reduction in the repo rate, six institutions revised FD interest rates effective February 2025.

 

Ujjivan Small Finance Bank, effective from 21 February 2025, now offers interest rates ranging from 4.25% to 8.75% for deposits under Rs 3 crore, with the highest rate of 8.75% applicable for 18-month tenures. Its Platina Fixed Deposit scheme provides an 8.45% rate for durations between 12 to 18 months. Similarly, Suryoday Small Finance Bank, effective from 1 February 2025, offers 8.75% on one- to three-year deposits and 9.1% on five-year deposits for senior citizens. City Union Bank and Shivalik Small Finance Bank also revised their rates, with City Union Bank offering 8% on 333-day senior citizen deposits and 7.25% on 334 to 400-day deposits, while Shivalik Small Finance Bank provides up to 9.05% on 12- to 18-month deposits. Additionally, DCB Bank and Karnataka Bank have adjusted their rates, with DCB Bank offering up to 8.55% for 19 to 20-month deposits and Karnataka Bank providing 8% on 401-day deposits. 

 

In this context, the key question for those contemplating putting money in FDs is whether to lock in current rates before they dip further or explore better alternatives.Fixed deposits remain a popular choice due to their guaranteed returns and capital protection, especially for risk-averse investors. However, investors should consider a few key factors before committing their money.

 

Penalties on Premature Withdrawals: Fixed deposits typically carry a penalty for early withdrawal, ranging from 0.5% to 1%. Additionally, interest is recalculated based on the actual holding period. For instance, an FD booked for five years at 7% but withdrawn after two years may earn the two-year FD rate (say, 6%) minus the penalty.

 

Taxation: The interest earned on FDs is added to the investor’s taxable income and taxed annually according to their income tax slab.

 

Currently, FD rates across leading banks range between 6.5% and 7.4% for tenures of one to five years. Small finance banks, however, offer rates as high as 9%, albeit with slightly higher associated risks. For those considering alternatives, debt funds, particularly short-duration funds and target-maturity funds (TMFs), offer attractive options.

 

Debt Funds as Alternatives: Short-duration funds, which invest in bonds with maturities of one to three years, and target-maturity funds, which hold bonds until maturity, are gaining popularity as FD alternatives. One key advantage of debt funds over FDs is the tax deferral advantage. While debt fund interest is taxed based on the investor's income slab, taxation is deferred until redemption, allowing for potential compounding benefits and improved post-tax returns. Additionally, unlike FDs, debt funds offer greater liquidity, with no penalty for premature withdrawals.

 

"Historically, short-duration debt funds have outperformed FD rates in nearly 70 to 80 per cent of cases over one- to three-year periods, based on rolling return analysis over the last five years.The yield to maturity (YTM) of target-maturity funds—the estimated annual return if held until maturity—currently ranges between 6.9 to 7.1 per cent, making them competitive against fixed deposits," said Ameya Satyawadi of Value Research. 

 

Value Research lays out the key risk factors with debt funds:

Before opting for debt funds, be aware of potential risks:

 

Interest rate risk: When interest rates rise, bond prices fall, negatively impacting the existing debt funds. However, shorter-duration funds experience less impact than long-term ones.

 

Credit risk: Some funds invest in lower-rated bonds, which carry default risk. Higher-rated bonds (AAA or AA) are safer but may yield slightly lower returns. 

Value Research compares performance of Short-duration funds vs Fixed deposits (FDs) ( Based on daily rolling returns of average short-duration fund against the SBI FD rates, over the last five years) 

 

 

What should investors do? 

"If you prioritise capital safety and guaranteed returns, locking in a long-term FD at current rates before they drop further is your best option, especially if you don't anticipate needing the funds before maturity. If you seek a combination of flexibility, potential for higher returns and tax efficiency, debt funds (particularly short-duration funds for liquidity and target-maturity funds for predictable returns) offer advantages over FDs despite their slightly higher risk profile," said Ameya Satyawadi of Value Research.