Fixed deposits (FDs) are the staple of the savings diet of Indian investors, with over 60% of household finances allocated to bank and non-bank deposits. Among the many reasons why fixed deposits are so popular is the perceived level of safety, proliferation of banks and the ease and convenience of making deposits.
If you are planning to invest in fixed deposits, here are the 5 most important aspects to consider while starting an FD:
1. Will the FD outgrow inflation to meet long-term goals?
Bank fixed deposit interest rates are in the 6.5-7.5% range right now and corporate FD rates hover around 7.5-9% currently. The question to ask is, will a 7% growth of capital suffice to send your daughter to B-school in 10 years or buy that dream home in 5 years? The answer lies in the inflation rate. Inflation is in the 5% range currently. When you consider the effect of inflation on the FD rate, your real return is approximately just 2%!
Now, the erosion effect of inflation is not directly observable. The bank will pay the contracted rate of interest on your deposit. Yet, the effect is real when you consider the purchasing power of the FD at maturity.
Here’s an example to simplify this. Suppose your 10-year FD purchased 1 basket of goods and services at the start of the FD term. Due to inflation the value of that basket goes up after 10 years. If your fixed deposit amount at maturity is insufficient to purchase the same basket of goods and services, then your FD has had negative real growth. And this scenario is possible, even at an interest rate of 7%, as illustrated in the next point.
Therefore, when it is about your long-term goals, say goals that are at least 5 years away, growth of capital should take precedence over the assurance of constancy of returns.
2. Are FDs the most tax efficient way to meet your goals?
Interest on fixed deposits is taxable according to your income tax bracket. This means if you fall in the 30% bracket, the interest income is taxable at that high rate. So, with tax and inflation, your real return can be paltry or even negative, as illustrated below:
|Scenario 1||Scenario 2|
|Real rate of return||-0.1%||1.2%|
Moreover, if the interest income is over Rs 10,000 in a year, TDS kicks in. This is highly inconvenient for those whose income is not in taxable limit as then they will have to submit form 15G/H to the bank at the start of the year to avoid TDS (tax deducted at source).
3. How feasible will it be to access your savings before maturity?
You may want to break your fixed deposit earlier than maturity when an unexpected need arises or to take the benefit of a higher rate. Banks allow premature withdrawal of deposits, but this comes with a penalty. Typically, 0.5-1% rate is charged as penalty on the applicable interest rate. The interest rate applicable for premature withdrawals is usually the lower of:
The rate applicable for the period the deposit has actually remained with the bank and the original contracted rate.
For instance, suppose you enter a 5-year deposit at 8.5% and your bank charges 1% penalty. You break the fixed deposits after 2 years and the interest rate for 2-year deposits have now dropped to 8%. So, the effective interest rate applicable for your deposit after the penalty will be 7% (which is 8%-1%). And the real rate after accounting for tax and inflation is -0.1%, as calculated above.
4. Are deposits absolutely risk-free?
Bank deposits are widely assumed to be risk-free because of the insurance cover on deposits. However, it is important to know that such insurance covers only up to Rs 1 lakh of your deposit. As such banks are tightly regulated institutions with stringent norms for capital adequacy, and the risk of losing capital is low. Yet, as we know from the situation of PSU banks today, banks can badly flout in their lending policies, amass NPAs (Non Performing Assets) of huge scale, putting depositors money at risk.
Risk is even more relevant for corporate deposits where your returns are contingent on the success of the particular project being financed with the bond or deposit. Deposits with higher interest usually have higher risk.
5. How do you achieve adequate diversification?
Wisdom teaches that it is better not to keep all eggs in one basket. From a pragmatic view, it is tough to diversify well with FDs. A depositor with Rs 1 crore may at best split the deposit across 5 banks or a few corporates. It becomes cumbersome to keep track of interest, tax liability, maturity dates, et cetera with too many deposits.
DFs – your better alternative to FDs
Considering the five concerns above, one can look at Debt Funds (DFs) as alternatives to Fixed Deposits (FDs). Debt funds are mutual funds that invest money pooled from investors in a variety of fixed income instruments like bonds, debentures, certificates of deposit and government debt papers. For investments over 3 years, a debt fund may serve your goals better than a fixed deposit for the reasons below:
# Since a single fund will invest in 20-40 different instruments, the diversification is so much greater.
# The presence of various risk components in these instruments usually mean their performance is better than bank FDs.
# Long-term capital gains (applicable to debt investments held for over 3 years) is 20%, along with the benefit of indexation. Indexation can lower your actual tax liability to a great extent.
# There are no lock-ins. So you can redeem investments earlier than planned, in case the need arises.
(By Amar Pandit, CFA, and the Founder & Chief Happyness Officer at HappynessFactory.in)