Investing in Fixed Deposit – Keep in Mind Negative Real Returns
Have you ever heard that a person who has invested his hard earned money in bank fixed deposit has suffered a loss? Confused? I know you will be. People usually invest in fixed deposits because they consider it to be the secure source of earning and believe that the money will only increase. Actually most of us have never thought that they can even lose their money in fixed deposit because of negative post tax returns. Let us understand that for most of us why fixed deposit is not a rewarding option of investment.
The Real Rate of Return Offered by Fixed Deposits
Fixed deposits are offered by institutions that are authorized by Reserve Bank of India to do so. These institutions may be banks, Non-Banking Financial Companies (NBFCs), Housing Finance Companies (HFCs), etc. These financial institutions offer 8.50% to 9.50% interest on their fixed deposit scheme for 1 year tenure. Let us understand the real rate of return from fixed deposits with the help of an example:
Let us assume that the amount invested by a person in fixed deposit is Rs. 1 lakh for a rate of interest of 8.50% per annum which is compounded quarterly and the rate of inflation is assume to be 7.50%.
Inflation rate of 7% means that the product that you might have purchased Rs. 100 sometime before will now cost you Rs. 107.50.
Now, when this inflation rate is combined with the tax rates applicable on the returns from your fixed deposits, it may generate a negative return to you.
On the investment of Rs. 1, 00,000 at 8.50% p.a. interest which is compounded quarterly (that is, the annual yield will be 8.77%), you will earn interest of Rs. 8770. If you fall in 0% tax bracket, 10%, 20% or 30% tax bracket then the post tax interest rate would be 8.77%, 7.87%, 6.96% and 6.06% respectively. If we combine the inflation rate with the post tax interest rate, then the effective rate of return would be 1.27%, 0.37%, (0.54%) and (1.44%) respectively and the effective return would amount to Rs. 1,270, Rs. 367, Rs. (537) and Rs. (1,440) respectively.
That is, the investor in the tax bracket of 20% and 30% has suffered losses. Instead of getting nay positive return, the returns accruing to them from investment in fixed deposit is negative. Therefore, people who fall in the tax bracket of 20% and 30% should be more cautious while investing in fixed deposits. People in the tax bracket of 0% and 10% can get moderate returns from the fixed deposits.
Comparison of fixed deposits with debt mutual funds
- The rate of return offered by debt mutual funds falls somewhere between 7% p.a. to 12% whereas the rate offered by fixed deposits is 7% to 10%.
- The returns from fixed deposits are fixed whereas since the debt mutual funds are linked to market, the rate of return on debt mutual funds tends to vary.
- Once you have invested in fixed deposit, you cannot increase or decrease the amount of the same fixed deposit, whereas in case of debt mutual funds, you can increase the level of your investments and if you want to reduce the amount of your investment, then you can redeem the same.
- Premature withdrawal from fixed deposit is allowed on a penalty of 1%. In case of debt mutual funds, one can redeem the mutual funds at any point of time. However, if the debt mutual funds are redeemed within 1 year then an exit load of 1% will be levied on the mutual fund holder.
- The principal and return are guaranteed in case of fixed deposit for a maximum amount of Rs. 1 lakh. Whereas, the debt mutual funds are exposed to interest rate and credit risk. Well, it is a matter of interest that if you check the historical values, you will find that there are certain debt mutual funds that has never given negative returns to the holders.
Since the return rate of debt mutual funds are more in comparison to rate of return of fixed deposits, the post tax return and effective return for a dent mutual fund will definitely be more than the fixed deposit.
Therefore, if you fall in the tax bracket of 30%, you should definitely stay away from fixed deposits and should better look for alternatives like debt mutual funds, tax free bonds, etc. I hope that the above facts will act as an eye opener for you and from now onwards, you will make an informed decision for your investments.
