A good investment strategy requires choosing the right mix of safe and risky investments. Among safe investments, fixed deposits, FDs, are the most popular today.
With FDs you deposit a lump sum of money for a fixed period ranging from a few weeks to a few years and earn a pre-determined rate of interest. FDs are offered by both banks and companies though putting your money with the latter is generally considered riskier.
What are the advantages and disadvantages of FDs?
The main advantage is that FDs from reputed banks are a very safe investment because such banks are carefully regulated by the Reserve Bank of India, RBI, the banking regulator in India.
Note that company FDs isn't as safe as bank FDs because if the company goes bankrupt you may lose your money. Make sure you check the credit rating of a company before investing in its FDs. You should be especially wary of companies which offer interest rates significantly higher than the average to attract your money.
The other advantage of FDs is that you have the option of receiving regular income through the interest payments that are made every month or quarter. This option is especially useful for retirees.
On the flip side, a fixed deposit won't give you the same returns that you may get in the stock markets. For instance a stock-portfolio may rise 20-30 per cent in a good year whereas a fixed deposit typically earns only 7-10 per cent.
A fixed deposit also doesn't offer protection against inflation. If inflation rises steeply during the maturity of the FD your inflation adjusted return will fall.
Say, for example, the inflation when you deposited the money at a fixed return of 8 per cent per annum is 3 per cent. Now when your FD matures say after 2 years, the inflation increases to say 5 per cent.
In this case, your inflation adjusted returns is only 3 per cent (8-5). Had inflation remained at 3 per cent by the time your deposit matured, your real rate of return would be 5 per cent (8-3).
Interest rates on FDs
The rate of interest on FDs varies according to the maturity with longer deposits generally earning a higher interest rate. Here are the interest rates offered by ICICI Bank on their FDs. Note that FDs vary quite a bit from bank to bank so you should search around before investing.
Interest paid on a fixed deposit is paid either monthly or quarterly according to the investor's choice. So if you invest Rs 3 lakhs in a one year fixed deposit which pays 8 per cent you can earn Rs 2,000 of interest every month or Rs 6,000 of interest every quarter.
Effective Return
Before you invest in FDs you need to understand the concept of effective return which is higher than the rate of interest on the FD. Effective return is relevant if you choose to reinvest your interest every year which means that you will be earning compound interest.
For example suppose you invest Rs 1,000 in a fixed deposit with 8 per cent interest which is paid quarterly.
In the first quarter (after 3 months) you will earn an interest of Rs 20 which is re-invested and continues to earn interest in the remaining three quarters. Similarly the interest you earn in the second (after 6 months) and third quarter (after 9 months) is also reinvested and earns interest.
At the end of the year because of compound interest you will receive Rs 1,082.4 meaning that your effective return is 8.24 per cent rather than 8 per cent.
What happens if you break a fixed deposit?
Breaking a fixed deposit means withdrawing the money before the maturity expires. This may be necessary if you urgently require the funds or if there are better investment opportunities elsewhere. You will have to pay a cost; for instance you may receive an interest rate 1 per cent lower than the stated interest rate on the FD.
For example if you invested in a 3 year FD with 9 per cent and you break it after two years you may receive only 8 per cent interest for those two year instead of 9 per cent.
An alternative to breaking a fixed deposit is taking a loan against the FD. Such loans are quite easy to obtain with amounts ranging up to 90 per cent of the principal and accumulated interest.
Are there better alternatives to FDs?
Obviously mutual funds and stocks can offer higher returns but the main issue is whether there are low risk investment products which offer a better return than FDs. Many financial experts believe that fixed maturity plans (FMP) offer exactly such a superior alternative.
Fixed maturity plans are similar to FDs in that they have a pre-determined tenure (say 3 years like the maturity of an FD) ranging from a few weeks to a few years. Your money is invested in fixed-income assets like governments bonds and money-market instruments which carry a low risk. The one major point where FDs score over FMPs is that the latter does assure you any guaranteed returns.
However, the main advantage of FMP's is that you can take into account inflation while calculating your taxes which means that your after-tax return may be superior to FDs, especially if you lie in the top income tax bracket.