An increasingly used financial tool, particularly for investors who are risk averse, are fixed deposits (FDs). They promise assured returns and little chance of losing your capital, providing a safe shelter for your assets. There is no denying the appeal of a reliable and secure investment.
But like any financial endeavour, fixed deposits could have some disadvantages of their own. It’s important to comprehend these dangers and how they could affect your financial objectives before investing hard-earned cash. This blog explores the possible drawbacks of fixed deposits, giving you the knowledge and confidence to make wise investing choices and manage your money. But first, let’s understand what a fixed deposit is and how does it work.
What is a Fixed Deposit?
A fixed deposit is an investment where you deposit a lump sum with a bank for a set period. The money earns interest at a fixed rate from the time you open the account. You can choose to receive the interest monthly, quarterly, or reinvest.
FDs are popular because they’re safe and guarantee returns without the risk of losing capital. They offer higher interest rates than Savings Accounts, making them a secure and appealing investment choice for stable and predictable returns.
How Does It Work?
When you open a fixed deposit, you invest a specified sum for a predetermined period, typically ranging from 7 days to over 5 years. You can’t withdraw the deposited amount until the FD reaches maturity.
The interest rate you earn is influenced by the duration of your investment and the amount you deposit. Generally, longer investment periods offer higher interest rates, leading to greater returns. The interest earned can either be credited to your account or reinvested in the FD at the end of the term.
Interest Rate Risk and Inflation Risk
These are two entangled factors. For the duration of the investment, the interest rate you locked in at the time of making the investment stays constant. This could become an issue if the market shifts and interest rates rise sharply over your locked-in rate.
Furthermore, inflation has the ability to gradually reduce the purchasing power of your money, even in the event that the interest rate stays unchanged. In the future, your money may grow nominally, but it won’t be able to purchase the same quantity of goods and services if the rate of inflation exceeds the interest rate on your fixed deposit.
Liquidity Risk
FDs lock in your money for a specified duration, unlike certain other types of investments. Even though some FDs allow for early withdrawal, these options frequently have penalties that reduce your total returns. Unexpected crises might happen, and having to access your money right away at a penalty point can seriously affect your financial objectives.
Opportunity Cost
Although profits on fixed deposits are assured, they might not necessarily be exponential. The fixed interest rate you get may not be as high as what you could make investing in stocks, mutual funds, or real estate. Opportunity cost is the term used to describe this lost chance to obtain larger profits.
Limited Growth Potential
Although they might be predictable and stable, FDs do not really offer the potential to expand rapidly. For short-term goals or emergency fund building, they can be an excellent instrument, but they might not be appropriate for long-term wealth generation methods where better returns are sought.
Tax Implications
In most cases, interest on fixed deposits is subject to income tax. Even if certain FDs provide tax advantages under certain circumstances, figuring out the tax ramifications of your investment is essential to determining your actual profits. A percentage of your interest may be deducted, depending on your tax bracket, which would further reduce your total gains.
Reinvestment Risk
At maturity, fixed deposit accounts offer a fixed return. However, if you plan to reinvest the proceeds into another FD, you may face reinvestment risk. Interest rates can fluctuate, so the new rate might be lower than your original rate, reducing your potential overall return.
Conclusion
While fixed deposits are a great option for more risk-averse investors, a comprehensive understanding of their limitations empowers you to make informed financial decisions. By acknowledging the potential drawbacks like the ones listed above, you can effectively integrate FD into your investment strategy alongside other options that might offer higher returns.