 "FDs should not be used for wealth creation: What investors should do instead")
Fixed deposits won't make you rich. There's no doubt that they are a safe investment, but bank FDs can actually negatively affect your savings in the long term.
There are two main reasons for this:
1. FDs give returns below inflation
The inflation rate in India has been high, and your fixed deposit may fail to give inflation-beating returns. You might get excited when banks offer an 8 per cent interest rate on a five-year fixed deposit. But you should calculate if the 8 per cent return rate is sufficient to match the pace of the rising inflation. Is this what you are going to get on maturity? The answer is No. This is because you have not considered the falling value of money due to inflation and taxation. Moreover, when tax is deducted from the interest income, returns on fixed deposits may fall below the rate of inflation.
Currently, the interest rate is around 7.5% p.a. on fixed deposits. For a deposit of Rs. 1,00,000, one will earn an interest of Rs. 7,500. If the deposit holder is in the slab of 30%, he would need to pay a tax of Rs. 2,340 leaving him a net interest of Rs. 5,160. This is effectively an interest rate of 5.16%. With the inflation hovering around 5.5%, the effective interest rate of 5.16% doesn't beat the inflation.
2: FDs are taxable, which further reduces the net amount you earn
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Compared with equity mutual funds, long-term returns are taxed at 10% for a holding period of more than 1 year, on gains of more than Rs 1 lakh. FD interest is taxable at your current tax slab. The higher your income, the lower your FD return will be.
Hence, when tax is deducted from the interest income, returns on fixed deposits may fall below the rate of inflation.
Data analysed by FundsIndia shows that even though FD Rates of large banks have increased in the recent past, post-tax returns are still below the fiscal year 2024 inflation expectation of 5.4 per cent.
There are two broad objectives FDs help fulfil: short-term holdings and assured income in retirement.
"FDs are not a good investment option because of the poor ‘real’ returns, i.e., returns after inflation and taxes, which will almost certainly be negative in most cases. On 8% FD, a taxpayer in the 30% slab will pay 10% TDS on FD interest and 20% taxes when they file their tax returns. Effectively, it’s 5.6% before inflation. If inflation is 6%, they’ve effectively earned returns of -0.40%, which means wealth has not been created but eroded," said Adhil Shetty, CEO, Bankbazaar.com.
Wealth creation can happen when you hold assets generating high ‘real’ returns
"Data says that equity has generated the highest ‘real’ returns in the past. For example, in a year where equity has generated 12 per cent returns, taxation of long-term capital gains from equity is 10 per cent, and inflation is 6 per cent, you’re looking at a minimum ‘real’ return of 4.8 per cent, which is 12x the FD returns," explained Shetty.
FDs, therefore, should not be used for wealth creation but for safe-holding wealth created.
Does this mean one should not invest in FDs?
"This doesn’t mean you shouldn’t invest in FDs. You need them for cash holdings for upcoming goals. Senior citizens need them for assured interest income. Senior citizens also have the unique benefits of (1) being eligible for higher returns, (2) tax-free FD income of Rs 50,000 a year under Section 80TTB, and (3) getting to pay a lower rate of income tax. This gives them better ‘real’ returns than anyone under the age of 60. That said, everyone should invest in an appropriate mix of equity, bonds, and gold for long-term wealth growth needs so that their capital—whether in retirement or otherwise—keeps growing," said Shetty.
What should your ideal FD strategy be?
It is advisable to invest in fixed deposits for the short term to take an interest-rate advantage. As interest rates are already high, it is best to ladder investments and invest them for shorter periods so that you can reinvest them on maturity to get higher returns. This means that rather than investing the entire corpus in a single FD, one can consider dividing their fund equally and investing it in FDs with different maturity periods. For example, if you have Rs 6 lakh to invest in FDs, split it into three parts of Rs 1 lakh, Rs 2 lakh, and Rs 3 lakh and invest in FDs with one-year, two-year and three-year tenures, respectively.
In the example above, when the first FD matures after one year, you can reinvest it for another three years. Similarly, when the second FD matures after two years, you can reinvest it for another three years. This way, you keep rolling over your FDs for longer durations and earn higher returns. Laddering will also take care of liquidity issues and provide you with regular returns periodically.
" During an inflationary period, it may be advisable to opt for short-term fixed deposits. This allows you to reassess your investment strategy more frequently and take advantage of potentially higher interest rates in the future,
according to the investing platform Koshex.
What should investors do?
Opt for a small finance bank
"While depositors having low-risk appetite usually consider fixed deposits and debt funds for their short-term financial goals, my personal recommendation would be to open FDs with small finance banks for investment horizons of 2-3 years. Many of these banks offer FD yields of 8% and above for 2-3 tenures, similar to the returns generated by most debt fund categories but with much higher income certainty and capital protection. Some of the banks offering yields of 8% and above include Unity Bank, Suryoday Bank, AU Bank, Fincare Bank and Ujjivan Bank. Moreover, debt funds no longer have the edge over bank FDs in terms of taxation. From this financial year, the capital gains from debt funds would be taxed as per the investors’ tax slabs," said Naveen Kukreja, Co-Founder and CEO, of Paisabazaar.
For those with low-risk, long-term horizon:
These should consider tax-saving FDs. "These FDs have a lock-in period of 5 years and the investment amount qualifies for tax deduction under Section 80C. However, the interest income is taxable as per the tax slab of the investor," said Kukreja.
Those with higher risk appetite:
Consumers having slightly higher risk appetite and having investment horizons of 3 years or more can consider investing in conservative hybrid funds. As per the SEBI regulations, these funds have the mandate to invest 10-25% of their portfolio in equity and 75-90% in debt instruments. "You can consider the direct plans of the SBI Conservative Hybrid Fund and HDFC Hybrid Debt Fund for investing in this fund category," said Kukreja.
Those with higher risk appetite and comfortable with 20-45% equity exposure:
Such investors should consider equity savings funds for investment horizons of 3 years or more, according to Kukreja. These funds invest in equity, debt and equity arbitrage opportunities. As the allocation to equity arbitrage opportunities are considered as equity-related investments for taxation purposes, these funds are considered equity-oriented investments even when the allocation to stocks reaches well below 65%.
"Thus, equity savings funds are best suited for those who wish to benefit from equity taxation but at very low equity exposure. While these funds usually generate returns similar to debt funds, their returns can be volatile depending on the equity market conditions, interest rate/inflation trajectories and the arbitrage opportunities available in the equity market. Some of the equity savings funds that you can consider are Mirae Asset Equity Savings Fund and SBI Equity Savings Fund," said Kukreja.