Before we jump the gun, let’s get the basics sorted.
There is no denying that Fixed Deposits are one of the safest investment instruments that you can get your hands on. But there is a catch (there always is).
Before we dive into the heart of the matter, let’s build the case by looking at some of the long-term pitfalls of investing only in Fixed Deposits (FDs):
1. Inflation Significantly Erodes Values
Fixed Deposits are at most likely to only get you your money back. The keyword here is ‘at most’. While a return of 7-8% may look lucrative on the face value, most of the investors forget to account for value erosion due to inflation. For instance, the graph below depicts the inflation rate in India in the past 5 years and the expected inflation in the near future.
This depicts the amount of money that any investment would lose over the years. In some instances, such as the years 2009 and 2012, inflation has been substantially higher than the ROI of Fixed Deposits. This essentially translates to negative returns.
2. Penalties on Exits Before Maturity
However comprehensive your investment plans be, there is always a high chance that you may need to dissolve your FD before your maturity period. Most of the banks levy a penalty of 0.5% – 1% in such cases. On top of this, your applicable interest rate may also change.
For instance, consider that you have invested INR 2 Lakhs in a Fixed Deposit scheme for 4 years. The applicable interest rate is 8%, bringing the earned interest to INR 72,090. Now, you decide to dissolve the FD after only 2 years. The applicable interest rate according to banking policies comes down to be 7.25% and a premature closure penalty of 1% is applied. Hence, the effective return rate comes out to be 6.25%. The earned interest now comes down to be only INR 25,780.
3. Fixed Deposits are Taxable
Just when you thought inflation was enough, taxes come into the picture. Fixed Deposits are taxed at a rate of 10% if the holding period is more than one year. And since the applicable tax depends on your current tax slab, the higher your income is, the greater the tax will be.
|Net Interest Earned|
|Post Tax Return|
This essentially means that a Fixed Deposit at an interest rate of 9% will give a return of only about 6.21% if the investor falls in the tax slab of 30%.
Example: Deep Dive
So, let’s understand how all of these factors work in tandem to erode the value of your investment. For the purpose of simplicity, we will make approximate and absolute calculations.
Consider a case where you invest an amount of INR 1,00,000 in a Fixed Deposit scheme for a period of 3 years and at an interest rate of 8%. At the end of 2 years, a certain need arises for which you want to dissolve the deposit. Here is what will happen to your investment:
- The average inflation rate for the past 2 years has been 5% (effective interest rate: 8 – 5 = 3%)
- The penalty of premature closure is 1% and the new rate of interest due to the change in the time period is 7%. (effective interest rate: 3 – 1 – 1 = 1%)
- The applicable tax rate on the interest is 2.4% since you fall in the 30% tax slab. (effective interest rate: 1 – 2.4 = – 1.4 %)
Forget about becoming rich. You would actually be losing money every year in such a case.
Fixed Deposits are far from ideal investment instruments and not suitable for investors who want to create substantial wealth. They should only be used as a short-term investment tool and as an alternative to savings.
What are your views about Fixed Deposit investments? Share them with us in the comments section.