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HOW DO DEBT INVESTMENTS WORK?

When someone has savings, he has two options:

  1. Buying something for a certain value and then selling it at a higher value: instruments like silver, gold, property, or company shares, OR
  2. Lending it to someone and earn interest till the time you get your money back: through government/ corporate bonds, fixed deposits at bank,  or savings account in bank.

Here we are to discuss the second option

Two entities are involved while ending money- a borrower and a lender. The borrower is in the need of money and lender doesn’t need it now. A fixed and regular payment is paid by the borrower to the lender. This regular payment is called interest in return of the privilege of having money. Once all the money is repaid, the loan gets closed. Bond, debt, credit are other words used for loan and these investments are referred as fixed investments as everything is fixed in prior like the repayment period, interest rate, etc.

A common example of debt investment or lending is saving in your bank account or making a fixed deposit:

One can lend his money to the bank in exchange of regular interest after deducting income tax. The bank will lend this money at a higher rate to other companies or people to buy commodities like car, home etc. The bank maintains a margin in the rates after deducting the loss incurred on loans it was unable to recover.

Another example is investment in a mutual fund:

Units are bought a certain NAV (Net asset Value) and are sold at a higher price at future. The difference is the earning after writing off the taxes. The money invested by you in the mutual funds will be utilised in buying corporate and government bonds to earn a regular interest. Government borrows money to invest in a variety of social initiatives like health schemes, defence and infrastructure if they haven’t collected enough funds through taxes. Companies may borrow to buy new things like factories or to maintain working capital for paying out to the vendor in case the customers will pay later.

So it can be seen that investing in your bank account is not completely risk free. Bank may invest in some wrong loans and will struggle afterwards to recover it. Also the fixed deposits at your bank are not tradable. They cannot reap you gains if sold before maturity. However, the rate of risk is very minimal as bank failures happen rarely and government is always there for the rescue. Just for this safety we pay steep prices as compared to the returns we get.

Thus it is recommended to invest in debt mutual funds so as to place your emergency funds or to meet up your short term financial needs. In terms of tax benefits or liquidity, debt mutual funds are always active over bank deposits. So you must diversify your old debt holding practices as per the time frame for your investment and take the maximum advantage out of it.

 

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