What are Fixed Deposits? -An in-depth View, How it works, Benefits, Risks

Fixed Deposits (FDs) have always been considered the safest investment avenue for Indians to grow their money. You must have often heard your parents advising you to set aside a portion of your income for fixed deposit plans. And there's no doubt about it - FDs have stood the test of time and consistently provided returns.

In this blog, we will dive into the world of fixed deposits, explaining what they are and how they work. We will also explore the unique features, benefits, and limitations of investing in an FD. By the end, you will have a clear understanding of fixed deposits and whether they are the right investment option for you.

What are Fixed Deposits?

Fixed Deposits, commonly known as FDs, are financial instruments provided by banks and Non-Banking Financial Companies (NBFCs). Unlike regular savings accounts, FDs offer higher interest rates and have a fixed maturity date. The tenure of an FD can range from as short as 7 days to as long as 10 years.

As the name suggests, FDs are fixed in nature. But, if you require funds, there are options available. You can initiate an early withdrawal of your fixed deposit before its designated maturity date. However, such a withdrawal is subject to specific conditions and penalties determined by the bank.

What are the Features of Fixed Deposits?

Let's now explore the distinguishing features that make FDs a potentially good investment option:

Loans

With FDs, you can avail loans of up to 80-90% of the deposited amount. This loan facility is crucial for depositors as it allows them to meet their financial needs without breaking their FD. It provides access to funds with little premium and enables them to maintain the longer-term maturity period of the FD.

Higher Interest Rate

Fixed deposits offer higher interest rates compared to conventional savings bank accounts. In fact, many banks provide even higher interest rates to senior citizens, making FDs a safe investment option for them.

Tax Saving

Certain categories of fixed deposits are eligible for tax savings under Section 80C of the Income Tax Act.

Cumulative FDs

Depositors have the option to receive regular interest payments or reinvest the interest and collect the entire payment at maturity in a cumulative manner. This system allows for higher interest earnings on the same principal amount. Such plans are known as Simple FDs or cumulative fixed deposits.

Auto-Renewal

Most banks offer an auto-renewal facility, which automatically renews the fixed deposit upon maturity.

Safe and Guaranteed Returns

Fixed deposits provide a safe and guaranteed return on investments, unlike stocks, mutual funds, or debt instruments. They offer fixed returns, shielding your capital from the sudden movements of the market.

Developing a Saving Habit

The lock-in period of FDs prevents easy withdrawal of funds, helping inculcate financial discipline. Knowing that a sum of money cannot be accessed until maturity eliminates the temptation to spend it on trivial things, fostering a saving habit.

Premature Withdrawals

FDs allow for premature withdrawals if you urgently need funds before maturity. However, withdrawing before maturity results in lower interest rates and may incur penalty charges.

Considerations and Disadvantages of Fixed Deposits

While fixed deposits have numerous advantages, it's essential to be aware of their limitations and considerations:

Low Liquidity

Fixed deposits have a lock-in period, which restricts easy access to your funds. It's important to consider this factor if you anticipate needing immediate liquidity.

Interest Rate and Inflation

The interest rate offered by FDs may be lower than the inflation rate, resulting in a decrease in the value of your money kept in FDs over time. It's crucial to assess whether the interest earned will adequately beat inflation.

TDS (Tax Deducted at Source)

If your interest income from fixed deposits exceeds ₹40,000, you are required to pay 10% TDS on the interest earned.

Benefits of Fixed Deposits

1. Safety: FDs are considered one of the safest investment options as they are backed by banks and financial institutions. The principal amount is generally insured up to a certain limit, providing a high level of security.
2. Fixed Returns: FDs offer predictable returns as the interest rate is fixed at the time of investment. This makes it easier to plan your finances and meet specific financial goals.
3. Liquidity: While FDs have a fixed tenure, they also offer liquidity options. In case of emergencies or unforeseen expenses, you can withdraw the funds prematurely, albeit with a penalty or a reduction in interest rate.
4. Minimal Risk: Since FDs are not subject to market fluctuations, they are relatively low-risk investments. They provide a stable avenue for individuals who prefer preserving capital rather than taking on market risks.

Factors to Consider Before Investing in Fixed Deposits

1. Interest Rate: Compare interest rates offered by different banks or financial institutions to maximize your returns. Higher interest rates can significantly impact the final payout.
2. Tenure: Choose the tenure based on your financial goals and liquidity needs. Longer tenures usually yield higher interest rates, but the funds will be locked in for a more extended period.
3. Penalties for Premature Withdrawal: Understand the penalties and implications of withdrawing funds before the maturity date. While it is possible, it may result in a reduced interest rate or other charges.
4. Tax Implications: The interest earned from FDs is subject to taxation. Consider the tax implications and factor them into your investment decision.

How to Open a Fixed Deposit?

You can open an FD by following 4 easy steps:

1. Research and choose a bank or financial institution that suits your requirements, considering factors like interest rates, reputation, and customer service.
2. Visit the bank's branch or use their online portal to open an FD account. Provide the necessary documents, including identification and proof of address.
3. Specify the deposit amount, tenure, and interest payout frequency (monthly, quarterly, annually, or at maturity).
4. Transfer the funds to the bank, either through cash, cheque, or online transfer.

Simple Interest vs. Compound Interest 

When it comes to FD returns, there are two types of interest calculations: simple interest and compound interest.

1. Simple Interest: In simple interest calculations, the interest is calculated only on the principal amount for each period. The interest remains constant throughout the tenure.
2. Compound Interest: Compound interest calculations take into account both the principal amount and the accumulated interest. The interest is calculated periodically and added to the principal, resulting in higher returns over time.

Understanding the Terminology

Before diving into the calculations, it's essential to understand the key terms associated with fixed deposits:

1. Principal Amount: The initial sum of money deposited into the FD. 
2. Tenure: The duration for which the FD is held, typically expressed in months or years. 
3. Interest Rate: The rate at which interest is earned on the principal amount. 
4. Maturity Amount: The total amount received at the end of the FD tenure, including the principal and interest. 

Interest on Cumulative and Non-cumulative FDs

In the world of FDs, there are two main types: Cumulative and Non-cumulative FDs.

Cumulative FDs

• Under this type, both the principal amount and the interest are paid out at maturity. 
• The interest earned each year is reinvested. This means you won't receive regular interest payouts but instead will receive a lump sum amount at maturity. 
• Cumulative FDs are suitable if you don't require a regular stream of income. 
• They also provide the benefit of compounding, as the interest for the next year is calculated based on the previous year's interest and principal.

Non-cumulative FDs

• With non-cumulative FDs, interest payments are made at fixed intervals. You can choose to receive interest payments monthly, quarterly, half-yearly, or annually. This provides you with a regular stream of income.
• However, non-cumulative FDs do not earn interest on interest, which is a downside compared to cumulative FDs. 
• Additionally, the interest rates on non-cumulative FDs are generally lower than those on cumulative FDs.

How to Calculate Interest on FDs?

To calculate the interest on your FD, three factors are important: the invested amount, the interest rate, and the investment duration. The basic formula to calculate the interest on your FD is:

Interest on FD = Amount Invested x Interest Rate x (Time Period/12 months)

However, this calculation varies depending on whether you have chosen a cumulative or non-cumulative FD. 

For example, if you have invested ₹25,000 for 3 years at an annual interest rate of 7.1%, your cumulative FD will have a maturity value of ₹30,712.

It's important to note that non-cumulative FDs provide periodic interest payouts, but compounding is not possible. Additionally, the interest rate on non-cumulative FDs is generally lower than that on cumulative FDs.

Key Takeaways

• Fixed Deposits (FDs) are safe investment options offered by banks and NBFCs.
• FDs have a fixed maturity date and offer higher interest rates compared to savings accounts.
• FDs allow you to take loans against the deposited amount or make premature withdrawals with certain conditions.
• FDs offer benefits like higher interest rates for senior citizens, tax savings, cumulative interest payments, and auto-renewal facilities.
• They provide safe and guaranteed returns, promote saving habits, and offer liquidity options.
• Factors to consider before investing include interest rates, tenure, penalties for premature withdrawal, and tax implications.
• To open an FD, choose a bank, provide necessary documents, specify deposit details, and transfer the funds.