Are Fixed Deposits The Right Option For You?
Understand the Fixed Deposit a little better and evaluate if it is the right instrument for you.
This post is about our good old friend, the Fixed Deposit. Let us explore the benefits and risks of FDs.
Not very long ago almost all savings went into Fixed Deposits. It was seen as the surefire way to earn money using savings. Before the mutual funds advertisement campaign, which made funds accessible to people, FDs were how most of us ‘invested’.
So, what are the advantages of an FD
The FD comes with a guaranteed return. The Bank promises you a particular return over a fixed duration of time and that is what you get. There is no risk to the capital. Irrespective of what the market or the economy does you will get the returns promised to you.
The rate of return is typically more than what you get in your savings accounts. It also moves the money out of your immediate reach. There is a penalty to withdrawing an FD before the tenure is up, thus discouraging you from fiddling with it. (penalty is usually in the form of a lower interest rate applied to your deposit)
While there is a penalty on premature withdrawal of FDs, the process is easy enough that your funds are accessible to you should you need them.
With FDs, you can choose when you want to receive the interest payment. You can receive it monthly, annually or at maturity. If you are looking at a predictable monthly income stream, then this could be an option.
You can also use FDs to save tax. The minimum duration is 5 years. You can get a benefit of up to 1.5 lacs under section 80C. This is the same section under which you get benefits for PPF, EPF, insurance premium, ELSS and a few others. So, for most of us salaried individuals, this section of tax benefit is already maxed out.
Unlike other investment tools, there is no commission involved here. You are paid the interest, that is promised.
To encourage customers to keep money in FDs banks are offering interesting incentives. One such incentive is ‘term insurance’. They will offer you term insurance with conditions such as ‘for first year’, ‘capped at 3 lacs’ etc. But really, term cover should not be the reason to opt for any financial instrument. Term Insurance is a critical aspect of personal finance.
Another interesting feature is that banks will give you a loan against your FD. This is a feature to be used in the rarest of circumstances.
The bank will give you a loan for a maximum of 95% of the deposit amount. They will charge you between 1-2% more than what they pay you.
The usual reason for this is to help you avoid a penalty for premature withdrawal of your FD.
So unless you stand to lose more than that amount in premature withdrawal, it does not make sense to use this facility. This is almost like paying the bank for the pleasure of keeping your money with them.
Let us now look at some of the down sides of the FD.
The Tax Man Cometh
The biggest issue with the FD is the tax rate. The interest you earn with FDs gets taxed at your slab rate. For most of us in decent earning brackets, this would mean 30%+ effective tax. That is a serious dent in the returns you get.
Very often you will hear about the good old days when FD rates were upwards of 10-12%. You could really make money from FDs in those days. From 1991 to 1999 FD rates were above 10%. Since then they have steadily come down and are in the region of 5-7% over the last few years.
Why is this you ask, why can’t banks give us the same 10% of the 90s.
Well, it’s the economy stupid!!
Inflation is the root cause behind this movement. In the 90s we had inflation at close to double-digit, peaking at 13+% in 91 and 98. Since then only 2010 and 2013 have had double-digit inflation.
What does that mean for the FD?
Inflation, as you know, reduces the value of your money.
So, you want to earn more money than you lose to inflation. Typically the FD will not help you do that.
Look at the table below. I have stacked the FD rate for the year, the inflation and the tax at 30%. This gives you the effective rate you are likely to earn from an FD.
Of course, this is illustrative only. The FD rate remains the same over the duration of the deposit whereas the inflation changes annually. But you get the idea.
Let us look at an illustration of what might have happened if you had put 1 lac in an FD in 2015. If you adjust for inflation, the 1 lac would be worth Rs. 95K by the end of 2020. Effectively you have lost 5% value of the money you started with. This was because of both tax and inflation.
Wouldn’t it be great if you could lock in a high rate of return just before inflation drops and stays low for a few years. If you can predict this, please do connect, I have a few other predictions I would like help with. :-).
FDs can be useful if you are a senior citizen, you get preferred rates. You also have a few tax advantages. Therefore, it might make sense for you to use the FD as a means of drawing a monthly income. In this case, you should shop around and make sure to first use the schemes like PMVVY and the Post Office savings where you get higher interest and more tax savings.
For the rest of us not yet eligible for this largesse, we need to look at better alternatives to the FD.
Debt funds come up as a good possible alternative. You can read about debt funds in this post comparing annuities.
For a quick comparison, the same 1 lac invested in 2015, if it were in the SBI Short Term Debt Fund, would have given you a 1.47 lacs after-tax, instead of the 95K with the FD.
Of course, you must recognize that there is a real risk with debt funds that you might lose the capital as well. Therefore, you need to do some research and be sure about what you are getting into. Do look up the Franklin Templeton case.
Summary:
Fixed Deposits are good for a particular use case. If you are not in a high tax bracket and you want to generate steady income, then it might make sense.
For almost every other use case there are other instruments that will give you better returns. Also, it is a myth that FDs are risk-free, with inflation you stand a real chance of eroding capital, not to mention the risk of the bank going kaput. I would urge you to evaluate other instruments such as debt funds and make an informed decision on how you want to invest your money. Always run the numbers yourself.
You can also read about the very basics and about the ten fundamentals while you are here.
Disclaimer: None of the opinions expressed here is to be treated as investment advice, please consult your financial advisor before making any investment decisions.
