Understanding the Risks and Rewards of Fixed Deposits

When it comes to saving your money, fixed deposits (FDs) are often considered a safe option. However, like any financial product, FDs have both risks and rewards. In this blog, we have outlined the many aspects of FDs so that you have a clearer idea before investing.

What is a Fixed Deposit?

A Fixed Deposit (FD) is a financial instrument offered by banks and other financial institutions where you deposit a lump sum amount for a fixed period at a predetermined interest rate. Unlike a regular savings account, where you can withdraw funds anytime without any penalty, premature withdrawal of FDs may incur penalties. The deposit tenure usually ranges from 7 days to 10 years. 

Rewards of Fixed Deposits

Let us study some of the advantages of fixed deposits and why they are still a prefered asset class today:

• Assured Returns: One of the primary advantages of FDs is the assurance of fixed returns on your investment. This makes them an attractive option for individuals who prioritise stability and security over higher-risk investments.
•  Capital Preservation: Unlike certain market-linked investments, FDs protect your capital from market fluctuations. Your principal amount remains intact throughout the tenure.
•  Regular Income Stream: Many individuals rely on interest income from FDs as a source of regular income. For example, this maybe an ideal investment for those who are retired and looking at regular income. 
• Tax Benefits: In India, Tax-Saving FDs offer offer tax benefits under Sec 80C of the IT Act. By investing in tax-saving FDs, you can lower your tax liability and increase your savings. Please note that Tax Saver FDs come with a lock-in period of 5 years.

Risks Associated with Fixed Deposits

While fixed deposits are generally considered safe investments, it is crucial to be aware of the potential risks involved: 

• Inflation Risk: FD returns may not always keep pace with inflation. Inflation erodes the purchasing power of your money over time, reducing the real value of your returns. For example, if your fixed deposit gives you a return of 6% and annual inflation is at 7%, your real rate of returns is -1%. 
• Liquidity Risk: FDs have a fixed tenure, and withdrawing your funds prematurely may result in penalties and lower interest rates. This means there is a possibility of it not being very liquid.
• Interest Rate Risk: Fixed deposit interest rates are determined by prevailing market conditions. If interest rates rise after you have invested in an FD, you may miss out on higher returns available on new deposits.
• Credit Risk: While banks are generally considered safe, there is always a small risk of default or bankruptcy. It is important to choose a reputable bank for your fixed deposits to mitigate this risk.
• Default Risk: Although rare, there is a possibility that the bank or financial institution where you have invested may default on its obligations. However, bank FDs are insured up to Rs 5 lakhs by the DICGC. 

Scenarios Where FDs May Not Be Suitable

While fixed deposits have their benefits, there are certain situations where they may not be the most suitable investment option:

1. Long-Term Goals: If your financial goals extend beyond 5 years, investing in FDs may not generate the highest returns.
2. Higher Risk Tolerance: If you can tolerate higher risk and are willing to explore other investment options, you may find better returns elsewhere.
3. Inflation-Beating Returns: If your objective is to beat inflation and maximise your purchasing power, FDs may not be the best choice.