Are Bank Fixed Deposits good for Short Term?


Bank fixed deposit

I get this asked quite often – it is well proven that equity is good for long-term investments but what about the short term?

What are the good saving and investment options for short-term goals?

There is no perfect answer that is applicable to all and everyone. But depending on the definition of short-term we are referring to (I prefer less than 5 years), a sensible advice would be to stick with debt for a major chunk of your savings for the short term.

Let’s come to the point.

Of the all available and suitable options that are there for short-term savings, Fixed Deposit is the most popular one in India.

Traditionally, most Indians are fairly accustomed and comfortable parking their savings either in bank fixed deposits or postal schemes. That clearly shows a bias towards safety and security of the principal amount. And to be fair, the bank deposits have been the instrument of choice of generations of low-risk common investors and savers.

And there is nothing right or wrong about it. It’s just about the preference and what one has been doing till then.

You already know…

What is a Fixed Deposit? (You can skip reading this)

It is one of the simplest saving-cum-investment product. And most importantly FD gives the depositors a feeling of safety.

You decide the amount you wish to park and then lock down this principal amount for a specified tenure. Tenure can range from few days to several years. On maturity, you get paid principal + interest (Cumulative FD). Or if you want, you can even receive periodic disbursal of interest amounts (Non-cumulative FD).

Atleast theoretically speaking, there is no risk of losing money with fixed deposits. Ofcourse inflation angle is there – which I will address later. But for people who have a fear of losing money, fixed deposits brings guaranteed returns over the specified tenure. This is like an ideal option for risk-averse individuals!

And practically speaking, all of us and I mean even the most sophisticated investors and financial smart heads would have indulged in bank FDs sometime or the other. Isn’t it?

FDs are good enough for (atleast) short periods

Yes. I don’t want to sound smart or something here. It’s a fact that if you value peace of mind and don’t want to maximize your short-term returns, then fixed deposits are good for short-term investment horizon as a risk-free option.

But you should not invest in Fixed Deposits (or even Recurring Deposits) for long-term – unless you are an ultra-conservative investor.

Bank Fixed Deposit FD Interest Rates & Inflation

Most people are curious to know as to which bank is the best for fixed deposit or where can they find the highest fixed deposit interest rates in India.

And that’s natural. We all want more buck for our hard-earned money.

If you check the data, then the historical FD interest rates in India have been all over the place.

Date of last 20 years of FD rates in India tells that it has ranged from about 5% to about 12% (give or take some depending on the actual FD tenor).

Someone recently asked me – what is the highest fixed deposit interest rate of all time in the history of India provided by any bank?

The answer it seems is that the highest fixed deposit rates in India since the 1980s is about 13%. And I was like wow – those were the good old days. 🙂 It was only after later 90s that the era of sub 10% interest rate became common.

On the other hand, the fixed deposit rates in India in last 10 years, i.e. recent past have operated in a much tighter range of 6% to little above 9%.

If you do an FD interest rates comparison and find out the fixed deposit rates of different banks, then more or less they are similar with a max of about a percentage point of each other. So unless you have tons of money to park in FDs, the answer to the question of which bank has the highest interest rate for fixed deposit will be not of much help.

The current rate of interest on fixed deposit is fairly low as the interest rate cycle is such.

But here is a thing – taxes eat up a part of this interest. Depending on the tax bracket you are in, the FD interest is taxed.

And when you compare the post-tax FD returns with prevalent inflation, which itself can fluctuate a lot, the fact is that it is difficult to keep up with real inflation by just putting your money in FD.

It’s still fine for short term. But should be really avoided for long term.

So if you are looking for instruments to save for long-term goals like children’s education, children’s marriage or your retirement, then FD is not the right instrument – even in the debt side of the portfolio.

If you don’t want to manually calculate FD maturity amount, then there are several online FD calculators that you can use to understand how your money grows when you put in bank FD. A fixed deposit calculator or FD calculator helps you calculate the maturity amount and interest earned for any Fixed Deposit account.

And here is something important…

Please don’t confuse Yield vs Rate of bank FDs. The actual difference between the annual yield Vs annual interest rate of fixed deposits FD is something that people should be aware of.

Many times, FD yields are used to misrepresent gains from fixed deposits. Here is the basic difference.

Annual Interest is different from Annual Yield. Suppose you put in Rs 1 lakh in bank FD giving 8% interest per year. Now at the end of 3 years (ignoring taxes), the value of your FD will be as follows:

  • Rs 1,08,000 at the end of 1st year = Rs 1.08 lakh
  • Rs 1,16,640 at the end of 2nd year = Rs 1.17 lakh
  • Rs 1,25,971 at the end of 3rd year = Rs 1.26 lakh

The annual interest rate is a constant 8%. But what about the annual yield?

It is calculated as follows:

  • Rs 1,08,000 / Rs 1 lakh = 8.00% / 1 = 8.0%
  • Rs 1,16,640 / Rs 1 lakh = 16.64% / 2 = 8.32%
  • Rs 1,25,971 / Rs 1 lakh = 25.97% / 3 = 8.67%

This is the annualized yield on Fixed Deposit.

So as you can see, it’s interesting but a fairly useless concept from a practical purpose. You will still have 8% per year even if the yield shown after few years is much higher.

Some entities will try to mislead you by telling ‘a 3-year FD with an annualized yield of 8.67%’ instead of 8% annual interest. And if the interest rate is higher, like say 10%, then the annualized yield will be higher.

Now take a guess which one of the two options below looks more attractive:

  • 3-year FD giving 10% a year, OR
  • 3-year FD with an annual yield of 11.03%.

Both are the same 🙂 …but you know what looks more attractive.

(Ignored taxes for simplicity)

Bank FDs vs Debt funds

In recent times, Debt Funds have been promoted as a good tax-efficient alternative to bank FDs. And there is a growing view that it is a better investment than fixed deposits.

Is it correct?

To be honest, debt fund vs bank FD needs a detailed post in itself (which I will soon publish). But let me talk a bit about it here.

When saving for short term, ideally one should understand that trying to maximize returns by taking a higher risk can result in negative consequences. And there is always more to investing than just tax-efficiency.

One cannot simply compare returns offered by either of them without understanding the risk taken to generate those returns. This might seem like a textbook cautionary statement but believe me, it is important to understand.

The post-tax returns of debt funds may or may not be higher than post-tax returns of fixed deposits.

But to be fair and as per recent historical data, the post-tax returns offered by good debt funds have been higher than bank FDs. Also its noteworthy that investors take credit and interest rate risk when investing in debt funds and ofcourse, you need to choose the right fund in order get the required returns (Not all debt mutual fund offer FD like returns.)

The interest earned from a fixed deposit is practically guaranteed. But the capital gains (or returns) from debt funds are not.

Another big reason for the recent popularization of debt funds is that the debt funds are far more tax-efficient than bank FDs when held for more than 3 years. So if debt funds are held for more than 3 years, the capital gains are taxed at 20% after indexation. And for all practical purposes, there is very little tax outgo after indexation benefits if held for several years. So it works very well for those who are in higher tax brackets.

In debt funds, one only has to pay capital gains tax as and when withdrawal is made. In FDs, tax payment ideally should happen every year.

Debt funds also allow partial withdrawals – this option is generally not available in FDs. So if you don’t know exactly when you will need the money or what part of it, then debt funds can be useful provided you have chosen the right category of debt funds.

But remember one thing – all debt funds are not same.

If you are searching for the best debt mutual funds to invest in, it is always advisable to understand what you are getting into. Or to put it very simply, know which debt funds are actually good for your needs. If you don’t know how to find this out, it’s best to ask an investment advisor to help you.

Recently, SEBI has forced mutual fund houses to categorize and rationalize all the mutual funds. This has also impacted the debt fund category.

I know there is something remarkably clean, simple, honest and risk-free perception* about FDs. J But both FD and debt funds can have a place in your financial life. You just need to know which ones are suitable for which financial goal of yours.

* To address this perception of risk-free nature: In general FDs are risk-free. But remember that if something unexpected was to happen, then in case of banks FDs, the Deposit Insurance and Credit Guarantee Corporation (DICGC) insures deposits of only upto Rs 1 lakh per customer. 

There is so much more to write about the FD vs Debt Fund debate. Or for that matter blindly comparing debt mutual funds vs equity mutual funds Or short term debt funds vs fixed deposits or ultra short term funds vs fixed deposits is not correct. I will do a longer separate post on this topic soon.

Tax Saving Fixed Desposits FD anyone?

One class of FDs also allow you to save some tax (Under section 80C).

Particularly known as tax saving fixed deposits, these term deposits under Section 80C usually come with a 5-year maturity period.

Generally, the 5 years fixed deposit interest rates are very close to other similar tenured FDs.

Personally, I don’t like using FDs for tax saving as there are better instruments available given the time horizon of 5 years for both conservative and aggressive investors – for example tax saving mutual funds or ELSS funds.

Fixed Deposits for Long Term Goals?

No.

Fixed deposits are not advisable for long term savings.

First of all, for most long-term goals, it is best to have higher equity allocation in the portfolio. And even within the debt part of the portfolio, preference should be given to instruments which offer higher post-tax returns in the long term – which bank FDs are unfortunately unable to.

Do not try to find out how to get maximum return from fixed deposit in long term. Long term is best served by equity and that is a standard and correct advice.

So don’t try to plan your retirement or children’s education savings (which are assumed to be several years away) using fixed deposits. A goal based investment plan can help you chose the right product for each and every financial goal that you have.

Don’t compare FDs vs Equity Mutual Funds

This comparison is not correct.

You are comparing apples to oranges.

Equity mutual funds are part of equity category and FD is part of debt category. So category in itself is different to so no point comparing.

Additionally, equity is suitable for long term goals whereas FDs are best for short term goals, that too better if less than 3 years.

Finally…

It is important to understand that once you are serious about putting your personal finances in order, you will realize that depending on the financial goals you have, you need to spread your investments in different kinds of investments.

So given the historical interest rates in India, bank FDs can be used for some of your goals. Ideally, the short term goals where you are not interested much in maximization of post-tax returns and don’t want to risk the capital.

Don’t think this as a fixed deposit investment tip but practically speaking, when the interest rate cycle turns and FD rates start peaking, it may make sense to open fixed deposits and lock in the interest rates at high levels for several years if you are an FD-lover. Also, if you really want to keep parking money in FDs, it makes sense to ladder your FDs with different tenures. By doing so, the highs and lows in interest rates will theoretically balance out over a period of time.

I don’t want to pass any judgement about FDs as a financial product here.

As a product may be suitable for someone and not suitable for someone else. But FD can be a wonderful and a simple way to begin the habit of saving for most people. So understand what your real requirement is and then use FDs to serve the correct purpose.



Source link

Be the first to comment

Leave a Reply

Your email address will not be published.


*