Why you should not invest in Fixed Deposits & Recurring Deposits for long-term

As per Reserve Bank of India’s ‘Handbook of Statistics on the Indian Economy-2014’ , the total investments made in bank deposits (including fixed deposits) by the Indian households were to the tune of Rs 6,722 billion. Around 57% of household savings are invested in bank deposits. So, Fixed Deposits and Recurring Deposits are the most preferred Financial Assets in India.

What are the main reasons to invest in a Fixed Deposit? Why are FDs/RDs the most favored investment avenue in India?

• Bank deposits serve the purpose of preserving capital (principal).
• They give a stable and fixed return on the invested money. We prefer to invest in ‘guaranteed’ returns oriented financial products. (Kindly note that Fixed deposits with Banks up to Rs. 1 lakh only are backed by deposit insurance.)
• Money in a bank account is safe.
• Bank Deposits have good liquidity. They can be closed and the principal can be withdrawn within a few hours / days.
• Ease of investing and convenience is also very high with bank deposits.
• If an investor had lost some monies by investing in Mutual Funds / stocks, he/she prefers to invest in safe bets like Fixed Deposits or Recurring Deposits. So, bad investment experience with equities is also an important factor.
• FDs and RDs are used as investment tools to achieve short-term financial goals and also to accumulate an emergency fund.

So there are lots of benefits investing in fixed deposits. But, are they tax-efficient? What about post-tax returns on Fixed Deposits? Can FDs and RDs deliver decent inflation-adjusted investment returns? Are Fixed Deposits good as long-term investment? Are there any other better fixed income investment avenues?

Fixed Deposits & Post-Tax Returns

On an average, a typical 5 to 10 year bank fixed deposit can generate returns of around 8 % to 9%. We generally talk about the pre-tax returns and do not give that much importance to post-tax returns (the interest earned on fixed deposit is taxable). Let us understand about the calculation of post-tax returns with an example.

For example – if you invest say Rs 10,000 in an FD at 9 per cent interest rate, interest earned during the first year would be Rs. 900. But, you need to pay taxes on the interest earned. If your income tax slab rate is 30%, that means you need to pay around Rs 270 as taxes.

The pre-tax returns from your bank FD is 9%. But after paying the taxes, the post-tax returns is just 6.3% only, which is much lower than the presumed return.

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

                               6.3% = 9 { (100 – 30) / 100}

Fixed Deposits & Inflation adjusted Post Tax Returns

We need to discuss one more factor here i.e., INFLATION. One rupee say in 1947 is not the same as one rupee today, both in terms of purchasing power and appearance 🙂 . Do you agree with me?

If inflation is around 8% and if your investment earns 7% returns then your wealth is getting eroded. You are actually not making any money. This concept is called ‘real-rate of return’ or ‘inflation-adjusted returns’.

Let’s continue with the above example to understand the effect of inflation. If you factor in inflation, the post-tax returns of 6.3% will come down to -1.57%. Indeed, you get negative returns on your investment.

Inflation adjusted & Post Tax returns = { [( 1+ post tax return ) / ( 1+inflation rate )] – 1 } * 100

                           -1.57% = { [ (1+.063) / (1+.08) ] – 1 } * 100

If you continue with a 10 year FD, just imagine the impact of taxes and inflation on the returns generated.

Below chart gives you an overview of how the investment value of a Fixed Deposit decreases over a 10 year period. In this example, I have assumed the rate of interest on Rs 10,000 FD as 9% pa (annually compounding), inflation rate as 8%, income tax rate @ 30% and the tenure of FD as 10 years.

Without considering the taxes and inflation, the maturity value of this 10 year FD  of Rs 10,000 would be around Rs 23,600. If you consider Inflation adjusted and Post-Tax returns of -1.57%, the maturity value is Rs 8,536.

(Same is the case with low-yielding investments like Life insurance money-back / endowment policies, these will give you negative returns. Do not mix insurance with investments)

When one should opt for Fixed Deposits?

One of the most important aspects of successful investing is spreading your money in different kinds of investments, depending on your investment period.

You can definitely consider investing in a FD / RD, if your financial goal is a short-term one and preserving the capital is your utmost priority.

For example – You want to accumulate a corpus to fund your Kid’s donation fee for primary education, over the next 12 months or so. In this scenario, opting for a RD / FD makes sense. Another scenario can be, when you want to accumulate a fund to meet any unforeseen expenses (‘emergency fund’), you may consider investing in shorter-tenure fixed deposits. Retired people could also make the best use of this avenue for securing a fixed and steady income.

Other Investment Avenues

Fixed income securities or Debt-oriented products should be part of your investment portfolio. There are no second thoughts on this. But the point is, try to identify and  invest in tax-efficient fixed income options.

These can be :  Public Provident Fund (PPF), Tax-free Bonds, Debt-oriented Mutual Funds, Hybrid Mutual Funds, Monthly Income Plans of MFs etc., If possible take little bit of risk and invest in a top-rated Company Fixed Deposit too.

Besides the above mentioned investment options, do consider allocating significant portion of your savings (disposable income) to Equity related investment avenues. Invest in Equity Mutual Funds (if not in direct equity – shares) for your long-term financial goals. They are not only tax-efficient but also can beat inflation.

Investment in a property (real-estate) can also be a better option (but prioritize your financial goals before investing in a property through a home loan).

If you prefer to invest only in Fixed Deposits and Recurring Deposits, it is for sure that your investment value (wealth) will get eroded over the years. If you choose to invest in various investment avenues, there is every chance that your portfolio can give you positive inflation adjusted post-tax returns. Do calculate the inflation adjusted returns on your fixed deposits & RDs (if any).

Do not allocate your entire savings to Fixed Deposits or Recurring Deposits just because they are safe and give your guaranteed returns. The caution is not to use the fixed deposit as a long term investment avenue. Remember, it’s the RISK that gives your money the best chance to GROW.

Continue reading :

• Traditional Life Insurance Plan – A terrible Investment option?
• Bank Deposits: Are you aware of this interesting fact?
• Best Investment options in India!
• FY 2018-19 Section 80TTB | Tax Exemption of Rs 50,000 on Interest Income to Senior Citizens

(Image courtesy of jscreationzs at FreeDigitalPhotos.net) (Education cess & surcharge not considered in calculations)