My wife and I do not have a single rupee parked in Fixed Deposits (FDs). This may seem radical but we do not think it is the right product for our needs. I will argue that whatever be your investment needs too, several issues make FDs a poor investment choice:

Costly Premature Withdrawal

Fixed Deposits, as it says in the name, come with a lock-in period. If you let the money stay with the bank for the agreed-upon period, you get the promised interest. The interest rates vary based on the tenure i.e. the duration of the deposit: the shorter the tenure, the lower the interest rate.

You can close the deposit before the maturity date, but that is considered a premature withdrawal. In such cases, the applicable interest is based on the duration for which the money stayed with the bank. For example, consider that you made a deposit for 5 years at 8% but withdrew it after 2 years. If the ongoing rate on the date of deposit for a tenure of 2 years was 5%, the interest will be paid at 5%, and not 8%.

You will also incur a penalty for premature withdrawal, which ranges from 0.5% to 1% and higher. Since partial withdrawals are not allowed, you may need to break a 500K 5-year deposit even if you need only 50K. Result: you get much lower interest on the other 450K too.

Tax Inefficiency

The interest earned from Fixed Deposits is treated as regular income and thus:

  • Taxed at the marginal slab rate and does not enjoy any indexation benefit. If you are in the 30%+ bracket, after taxes, you get less than 70% of the promised interest.
  • Can not be adjusted against capital losses, from mutual fund investments or stock trading

Also, the accrued interest is liable for taxes in the same financial year and not when the deposit account is closed. The intermediate taxes further lower the gains due to the time value of money.

Risk of Concentration

Most people keep the majority of their FDs with a single bank; some spread them across two banks at most. Those who invest in Corporate Deposits1 (CDs) might, for instance, put 10-20% of their money with one company. Such a tight spread of funds results in the risk being extremely concentrated: if even one of these entities has less-than-stellar financial health, the risk of losing a sizable chunk of your money becomes non-negligible.

The risk is not merely a theoretical one. Time and again, we see such seemingly unimaginable events pan out in real life. The insolvencies of Punjab and Maharashtra Co-operative Bank (PMC) and Lakshmi Vilas Bank (LVB) are some recent examples. In 2019, the now infamous Future Group disallowed withdrawals of CDs for a few months.

One universal rule of finance is that returns and risk are inseparable: you cannot get high returns without taking up higher risk. In all the above cases of failures, the depositors were promised higher-than-average returns — the telltale sign of risk.

These days, the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act2 insures all bank deposits in India, up to a limit of 5L. The coverage limit used to be 1L earlier; the Modi govt increased it in 2021 after several cases of bank failures. But if you have put more than 5 lakhs in a bank, which then fails, the scheme would prove to be insufficient. Also, note that DICGC only insures banks, and not Corporate Deposits or from NBFCs.

Fixed Deposits are straightforward to understand and effortless to get started with but they offer poor returns in practice. Also, despite the common belief, not all fixed Deposits are 100% safe. Well-diversified debt mutual funds are a much better investment option. We will cover them in a future post.

  1. CDs are similar to bank FDs but in this case the borrower is a company rather than a bank. ↩︎

  2. https://rbi.org.in/history/Brief_Fun_DepositInsurance.html  ↩︎