What comes to your mind when you hear the term fixed deposits? I am sure the very first word that strikes your mind is safety. After all, the ¡®safe¡¯ nature of fixed deposits has been the prime reason behind them being the best friend of so many generations of investors. Especially for the conservative ones, bank FDs are the first port of call whenever they wish to invest their surplus money. However, have you ever wondered that there can be risks associated with bank fds? And that too not one but multiple risks. Yes you read that right. While there¡¯s no denying the numerous benefits that FDs hold, it's equally important to know the risks as well. Eager to know them? Read on as we answer this frequently not asked question of lesser known risks of investing in bank fds.
Bank FDs primarily involve five types of risk-Liquidity risk, risk of default, risk of reinvestment, risk of wealth erosion and last but not the least, the risk of locking fd at low rate for long tenure.? While a lot of FD investor's own decision making impacts the presence and degree of these risks, its first important to know and understand these risks.
We all know that bank FDs can be liquidated easily by breaking it in case we face a financial shortfall during the FD¡¯s tenure. However, do you know that for all such premature withdrawal or closure of FDs, you need to pay a penalty? Most banks penalise premature withdrawals of FDs by levying a penalty of usually around 1% on the effective interest rate of the FD. Now what is this effective interest rate? It refers to the lower of the original booked FD rate or the FD card rate applicable at the time of opening the FD for the corresponding period for which the FD remained in effect.?
For example- Assume you had opened an FD amounting to Rs 10,000 at a booked rate of 6.5% p.a. for 3 years (compounded quarterly), and the bank levies 1% penalty on premature withdrawals. In case you had to withdraw the money on completion of 1 year of FD, bank would deduct 1% rate either from your card rate on the date of deposit, corresponding to the 1 year effective period of deposit(assuming the rate as 5.5% p.a.), or the contracted FD rate for the entire original 3 year tenure (6.5% p.a.), whichever is lower.? Implying, in this case your FD closure amount would be Rs 10,561 (5.5% p.a.), instead of Rs 12,134 which you would have accumulated at 6.5% p.a. in case of completion of FD¡¯s 3 year tenure.?
Besides this risk of attracting penalty on premature withdrawal or closure of bank FD, another form of liquidity risk looms over bank FD investors. That is, in case you had invested in a 5 year tax saver FD, your money would get locked in for a minimum period of 5 years, as most banks do not allow premature withdrawals or closure from these FDs. Hence, in such scenarios, you will not be able to access your own hard earned money when faced with financial shortfalls.
Also read:?Does It Make Sense To Invest Your Money In A FD Anymore?
While bank defaults are rare, but not impossible. Even in the recent past, bank crisis cases like the PMC Bank, LVB Bank, Yes Bank etc were themselves an indication of how banks can fail or come to the brink of failing. But remember that in case of bank failures, DICGC, a subsidiary of RBI, offers a cover of up to Rs 5 lakh per bank per depositor for cumulative deposits, including fixed deposits, savings account, recurring deposits and current account, opened with scheduled banks. Also, in all such scenarios of bank crisis, although the RBI does step in and take corrective measures to safeguard people¡¯s money to maximum extent, the insurance cover in itself is till Rs 5 lakh only. So, in case you have a higher amount of money deposited in the bank facing a crisis, you are still at the risk of losing that money, or at least being at the receiving end of facing restrictions in its withdrawal, in case the bank shuts down or continues to remain under fire.
Lack of indexation provision coupled with presence of generally low interest rates hovering around the inflation rate, pose the risk of wealth erosion in case of bank FDs. Unlike debt funds, which offer the benefit of indexation (method used to adjust the purchase price of an investment to reflect the effect of inflation on it), bank FDs do not offer this benefit. On top of that, returns on bank FDs, which are currently widely ranging around 2.5%-5.5% p.a. across most public and private sector banks, barring some small finance banks which are offering up to 6%-7% p.a on FDs, usually do tend to hover around the inflation rate, which was announced at 4.48% for October 2021. So, post deduction of taxes like TDS on interest income above Rs 40,000 in a year, and the applicable tax rate as per your slab after adding the interest income to your annual income, the leftover money on the already low interest rate on bank fds, can in fact make the net value as close to nothing, after accounting for inflation.
This risk is higher for those investing in FDs for long tenures like 5 years. Given that bank FDs lock the interest rate at which it was booked, there¡¯s risk of locking the FD at low rates for long tenures, which would even mean you have to bear the pain of low returns if you tend to rely on the FD¡¯s interest income, like monthly or quarterly payout, as a fixed income investor.
While opening your FD, you are given the options like withdrawing the accumulated amount (principal plus interest) upon maturity or you can go for reinvestment option, wherein the entire interest accumulated gets reinvested upon maturity. Now, in case you opted for the latter option of reinvestment, FDs that are due to mature soon during a falling interest rate regime are bound to get offered a lower rate at the time of maturity. Hence, you stand at the risk of not getting the best possible interest rate at the time of maturity, in case you had opted for this reinvestment facility. That's why it's usually advisable to not to go for it, and instead book a new FD at the best possible rate and chosen tenure once your FD matures, so that you can fetch the best deal for your hard earned money.
For more of such interesting financial content,?click here.
Click here?to download CRED