5 Risks of Investing in Fixed Deposits

Risks of Investing in Fixed Deposits

Every good investment product obviously also has some downside risks to it and that is no different in the case of fixed deposits. One obvious disadvantage people often talk about is that FD interest rates are relatively lower and that makes the fixed deposit account less attractive as an investment option. However, investing is not just about returns but also about stability and reliability of returns and that is where the FDs fit in. 

However, as we know, bank FD is not just about returns but also about other factors like flexibility, simplicity, assurance, liquidity etc. In fact bank FD is the only product that offers a more attractive senior citizen interest rate to attract retired and aged customers. In addition, there is obviously the risk that tax on fixed deposit interest is at the peak rate of tax and also there is TDS deducted by the bank once interest crossed the threshold. 

Five key disadvantages of investing in fixed deposits as an asset class 

While the Bank FD is considered to be one of the safest instruments when it comes to investment, it is crucial that you fully understand all the risks associated with it. Given below are certain risks pertaining to bank FDs: 

a) The first major risk pertaining to Fixed deposits (FD) is the liquidity risk. On the one hand, the bank FDs are relatively safe and secure due to the implicit guarantee. However, the FDs are locked for a tenure and hence there is the risk of not being able to come out. The liquidity is a major problem for corporate FDs and some NBFC FD, where there is no exit option. However, bank FDs can be either terminated prematurely by paying a small charge or it can also be used to take a loan against the FD.

b) There is risk of default in non-FDs. However, there are some things you need to be cautious about. For instance FDs by corporates and by NBFCs do not have any deposit guarantee. They are only based on the cash flows and the reputation of the issuer of the FD. However, in the case of bank FDs, there is deposit guarantee up to Rs5 lakhs per individual, including FDs. While in India banks have never been allowed to fail, technically, your FDs will only be eligible for insurance cover up to Rs5 lakhs including your savings account in the particular bank across branches.

c) The risk of inflation is a unique risk to most of the debt instruments and FDs are no exception. For instance, when you invest in an FD, the rate of interest is fixed at say around 6.5% currently. However, if inflation rate is around 7.5%, as it is now, then you are earning negative real rate of return. That is the inflation risk that you are exposed to even in a secured and relatively safe bank FD.

d) FDs are generally known to be tax inefficient. For instance, if you are a senior citizen above the age of 60, then you can avail tax benefits under Section 80 TTB of the Income Tax Act. However, in the case of you are under 60, then your entire interest earned on bank FDs above the basic exemption limit of Rs5,000 is fully taxable and at the peak rate of tax applicable. If you are in the 30% tax bracket, that is the tax rate you pay on FD interest. That wipes away a good chunk of your earnings.

e) Finally, there is the risk of reinvestment at healthy rates. FDs pay you rates of return of around 6.5% currently. However, if you earn regular interest annually or semi-annually, the assumption is that the interest so received is reinvested in assets with similar or higher returns than the FD. That does not happen in reality. That will expose FDs to reinvestment risk.

Notwithstanding these risks, FDs are still an attractive play owing to its stability, security and reliability.