The pros and cons of investing in fixed deposits

Traditionally the most favoured investment avenue in India, bank deposits continue to hold fort even today. The total fixed deposits with banks in India amount to a whooping Rs 35,68,435 crore (Rs 35,684.35 billion) as per Reserve Bank of India data. Bank deposits do not have the excitement surrounding other investment avenues like equity shares or real estate investments. But bank deposits serve the purpose of preserving capital, which is the most wanted at certain times.

Current income

Bank deposits are most sought after for this purpose. They give a stable and fixed return on the invested money. Traditionally, the interest rate is fixed during the tenure of the fixed deposit. Some banks now-a-days have gone for the reduction in existing bank deposits too, when the market interest rates come down.

The income comes to us in the form of "interest" for the deposit amount. The principal (initial amount invested) is returned back to us at the time of maturity. There are options to receive the interest on a monthly/ quarterly / half-yearly or yearly basis. In case we do not need the interest to come to us during the term of the deposit, we can opt for the cumulative deposit option, where it is credited to the deposit and earns additional interest. Interest is generally compounded on a quarterly basis.

The historical average return from fixed deposits in India is approximately 8 per cent for long term deposits (5 years). The highs and lows have been in the range of 13 per cent to 4 per cent.

Capital appreciation

Capital appreciation does not apply to bank fixed deposits. Only the principal invested is returned back at the time of maturity.

Risk

Perhaps the main reason for investment in bank deposits is safety of the principal. The capital (only upto Rs100,000 though) has the highest safety compared to any other investment as it is guaranteed by the Deposit Insurance & Credit Guarantee Scheme of India. All banks operating in India are covered under this scheme.

More than this guarantee, the close monitoring that RBI has on all banks in India is a big advantage to the safety of the investors in fixed deposits.

The risk faced when investing in bank deposits is the interest rate risk. This is associated with the lost opportunity to invest in an instrument that has a higher return. Getting out of a fixed deposit can be costly (up to 1 per cent of the principal), when we exit prematurely.  So we may have to forgo potential earnings when the interest rate has risen only by about 1 per cent.

The highest risk faced with fixed deposits is the effect of inflation. The real return after adjusting for inflation is very less or sometimes negative for fixed deposits of banks. This is a big burden, particularly for retired people, who have invested their retirement proceeds to get regular income. Their income may be regular and steady but the money's worth keeps going down during the tenure of the fixed deposit.

Liquidity

Bank deposits have good liquidity. They can be closed and the principal withdrawn within a few hours in some banks to a couple of days in others.

The other option is to take a loan on the fixed deposit. Banks lend upto 90% of the principal of the deposit. Interest charged for this is only about 1 to 2 per cent and only for the period that we have used the cash (The feature works like an over-draft against the fixed deposit).

Tax treatment

Bank fixed deposits are not tax efficient. The interest is taxed. Also there is no benefit from making the investment.

There are the 5-year bank deposits (tax saving) that give benefit under section 80C of the IT Act. But the benefits such as partial withdrawal or closure, and loan facility are not available. The deposit rates are also lower compared to the normal fixed deposits. This effectively negates the tax saved.

Convenience

This is pretty high with bank deposits. The investments can start from very low amounts (Rs 100 in most cases). There are no upper limits for investment. However, investments above Rs 50,000 will require your PAN card.

For a regular saving for a short period (up to 2 or 3 years maximum) the recurring deposit option can be made use of. Most banks offer standalone deposit accounts, though some may ask for starting a linked savings account.

The deposit periods can even be for very short periods starting from 15 days. This helps us to temporarily park funds before we could decide on an investment or an expense (choosing the wedding ring or buying a car for example.)

Fixed deposits can also be linked to savings accounts of banks in the form of a sweep-in-deposit. This gives the benefit of higher rate of return (when money is in excess) and flexibility to use the money when required.

In conclusion

The bank deposit primarily serves us to preserve capital. Banks now-a-days have added a lot of additional benefits to the traditionally benign service. Retired people could make the best use of this avenue for securing a fixed and steady income.

The caution is not to use the fixed deposit as a long term investment avenue. The reason is that the real return is very less when adjusted for inflation. The tax treatment of the interest also eats into the returns.