5 Reasons you should not invest in Fixed Deposits

(Last Updated On: September 19, 2016)

Fixed Deposit

Fixed Deposits or their close cousin RD’s ( Recuring deposits) are the most popular saving instrument in India.According to RBI,Indians invested approximately Rs 6800 Billion in fixed or bank deposits that means more than 55 %  household savings are invested in Bank deposits.

While Fixed deposits are popular because of risk-free nature of the asset and relative ease of investing and managing. They are not the best investment instruments to grow your money.Here are 5 reasons why they suck .

1. Post-tax Returns suck on Fixed Deposits 

Next time a banker tells you that this FD has got a return of  8 %. You need to take it with a pinch of salt. Fixed deposits attract TDS so the actual return after tax will be lesser than the sticker return.

You can calculate post-tax returns in a simple way see one example below.

So let’s say you have Rs 10000 of FD, at 8 % interest will get you Rs 800 rs interest , but with a tax rate of 30 % , you will only get Rs 560 , that means an annual return of 5.6 %

Simple formula to calculate this is :

    Post-tax returns = Pre-Tax returns * { (100-Tax Rate) / 100 }

Ok, lets put things in perspective, if you include tax into calculations your FD return will be reduced by your tax rate so,for people in 30 % bracket, it will be reduced by the same.

Below table explains how your post-tax return will look like on your FD Rate

 

Tax slab Post Tax Returns *
Below Taxable Income 8%
10 % Tax Slab 7.20%
20 % Tax Slab 6.40%
30 %  Slab 5.60%

*Please note that I have rounded off Tax rates so returns show are little higher.

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2. Inflation adjusted Returns can erode your income:

After taxes what can hurt any investor is inflation before I explain how, let’s look at average CPI-based inflation in India in past few years (source RBI data)

Inflation In India

If you look at the table above Consumer inflation in India has been hovering around 6% . So any asset class whose post tax return is 6 % or less, is actually reducing your wealth.

Inflation adjusted rate ( Real Interest rate) = Nominal Interest Rate – Rate of Inflation

Taking the example above. If your FD is giving a return of 8 % and you are in 30 % tax bracket. Your post-tax return is 5.6 %. Now  if inflation is 6 %,then your wealth or savings are going to erode approximately at the rate of 0.4 % per annum. Inshort with inflation hovering around 5.5- 6% most of the FDs give negative rate of return

3. Liquidity comes at a cost 

FDs are supposed to be liquid means you can  withdraw money at any time at a short notice. But most of the time this liquidity comes at a cost  most big banks charge a penalty of 0.5-1 % for premature withdrawal. One tip to overcome this is to  create multiple small FDs rather than one single FD.

4. Tax is always deducted at source

One more problems with FDs is tax deduction happens at source unlike some debt mutual funds, where you can defer taxes and hence your capital can grow much faster, let me explain this more let’s take the example I used in point 2, if you have an FD for 10,000 your interest rate is 8 % so you earned Rs 800 as a tax, now post deduction your interest is Rs 560 and hence your new principal is 10560 as a result you have lower base to grow, in case of debt mutual funds, you can keep on deferring tax till you withdraw and hence your money can grow faster.

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5. You can easily beat returns with almost not additional risk 

You can easily replace your FD portfolio by investing in short-term debt instruments and liquid funds, to get additional 1-2 % of returns. Liquid funds invest in short-term securities with maturities less than 91 days. Depending on the fund investments can be in government securities or short-term corporate bonds. Short term debt funds also invest in mix of g-secs and SCB’s but with a maturity of 91-180 days.

To read more about liquid funds read my post on All you want to know about Liquid Funds

Verdict

While Fixed Deposits have been a very popular saving instrument for individual investors in India. In terms of risk-return mix, they compare unfavourably with liquid funds and Ultra short-term debt funds. At the same time if you are investing for periods longer than 3 years you debt/liquid funds provide tax shield by postponing your taxes hence letting your money grow fast along with indexation benefits which take care of inflation.

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