(From my post at Yahoo)
In a new notification, the RBI has provided for a complete savings bank rate deregulation, in which banks are allowed to set their own rates for savings bank deposits.
A savings bank (SB) deposit is what is called a checking account abroad, which you can write cheques against, and where money is withdrawable "on demand".
I write about how short term debt mutual funds have done way better than fixed deposits and are tax efficient as well, in "Reconsider that Fixed Deposit”
"Inflation rears its ugly head again, as RBI prepares to raise interest rates." You hear this all the time, and then wonder why you should bother. Over a year now, we, the retail public have been getting horrendously low deposit rates from banks. And if we got a bank offering us 9% deposit rates, the interest was taxed; and at the highest bracket, our real return was only 6.3%.
But this sounds incongruous with what the papers are telling us — that liquidity is tight, or that banks want money. If they are, why aren't we getting better deposit rates?
I have an emergency fund — 6 to 12 months of expenses — in a safe avenue, but I don't know if this emergency will happen in 1 month or after 5 years. My putting the money in a fixed deposit yields very little; plus, I end up paying tax on the interest. And if I use a longer term deposit, I get hit by a pre-closure penalty if I should have an emergency in the meantime.
So we've got three issues — we don't get the best interest rates, we pay taxes on the interest even if we reinvest it, and we fear pre-closure penalties. Is there a way around this, retaining the same safety as a fixed deposit?
Enter the debt mutual fund. Mutual funds are assumed to have equity exposure, but that is a fallacy; in India, more than 80% of mutual fund assets are in non-equity investments, mostly fixed income products. These invest in markets where money is traded, like call money markets, fixed income derivatives, bond markets; here, what you would get for a 1-year investment with the same bank is likely to be higher than what the bank offers for retail deposits.
For example, on Tuesday (18 Jan), an HDFC bank "Certificate of Deposit" (CD) was available at an interest of 9.74% for one year (You can see what was traded at http://www.fimmda.org) The best HDFC Bank Deposit for a one year term is 8.25% - so the difference is substantial. You and I can't participate directly in these markets — plus, ticket sizes are 1 crore or more. The way to get in is to invest through a debt mutual fund; in this case, "ultra short term" or "floating rate" funds. They buy these CDs, charge a management fee of the order of 0.5%, and give you the rest. Read the rest of this entry »
Meaning, if you earn more than 2.5 lakhs a year, you would pay 30% (+3% cess = totally 30.9%) on income from a fixed deposit. Liquid funds which usually pay out dividend often (weekly, daily) now have to pay 25% on the amount they distribute, plus 10% cess and 3% education cess (28.325% in total).
But I maintain that even with this, you pay far lesser for a liquid fund than you do for fixed deposits, if you make more than 2.5 lakhs a year. Here's how.
Let's assume that you invest Rs. 10,000 in either avenue. And let us say both earn the same return - 10% per year.
In an FD, you will get Rs. 1000 as interest. And you have to pay 30.9% of this as income tax - that's Rs. 309 gone - and you're left with Rs. 691. That's an effective return of 6.91% for the fixed deposit.
Now let's say a liquid fund (which you bought 1000 units at Rs. 10 NAV) earned Rs. 1000, which means the NAV stands at Rs. 11 today. Now the liquid fund wants to pay out Rs. 1000 as dividend. Does it declare Rs. 1000 as dividend and pay 28.325% dividend tax? No!
The NAV will drop down after paying dividend. How much is required so that the NAV comes down back to Rs. 10 (so that your "principal" is maintained)? They will declare Rs. 7.79 as dividend per unit. The DDT for this is Rs. 2.21 which they pay the government.
Let's see how much you make, for your 1000 units. You get Rs. 779 as dividend, which means a net yield of 7.79% for a liquid fund.
The tax advantage is obvious: At 10% gross return, you pay Rs. 30.9% tax for a fixed deposit and only 22.1% tax for a liquid fund.
And another benefit is penalties - if you pre-close an FD, you will lose some of the interest because they will give you a lower rate for the period you used. Liquid funds have no such penalties and you get the full interest for all the money you use.
Note though, that liquid funds have varying yields based on the rate of interest currently in the market. FDs freeze the interest rate. Therefore, in a regime where interest rates are coming down, it is perhaps better to use an FD to lock in a higher interest. But at this point the interest rates are going up, and liquid funds are a better alternative there too - as the increase in rate will immediately reflect on your return.
The only advantage of FDs is the fact that you get money post DDT. So for the example you see only Rs. 779. Banks only deduct 10.3% TDS, so you would see Rs. 897. But of course you'd have to pay tax later anyhow.
Why would you choose a fixed deposit in this scenario? One reason can be that liquid funds don't want investments less than Rs. 50,000. But that's just the first entry, subsequent purchases can be of much lesser, Rs. 10,000 or so. If you can gather the initial Rs. 50,000 - even temporarily borrowed - you can stay in and get a better return.
For corporates this is even better - they pay 33.99% tax on other income, but dividends are tax free. Liquid funds which effectively have lower tax still outperform bank fixed deposits. So much for plugging the arbitrage!
Copyright (C) Deepak Shenoy 2011
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