How to choose between bank deposit schemes

Last Updated: Sun, Jun 10, 2012 10:07 hrs

Bank deposits do not offer the kind of rates other investment avenues like equities, real estate or even gold offer. Still, most Indians are bound to have at least one bank deposit account (mostly it is between 3 and 4). Why? Bank deposits are considered risk-free. Bank deposits give a stable and pre-defined return on the money you invest. The historical average returns from fixed deposits is approximately 8 to 10 per cent for longer terms like 3 and 5 years.

Stock markets are subdued for the last couple of years, gold prices continue near all-time high levels and real estate has been astronomically costly for years at end. As a result, the traditional investment option or bank fixed deposits have become more attractive than ever before for investors.

Bank deposit is a liquid avenue, that is, you are allowed to withdraw from it prematurely albeit for a penalty of 1-2 per cent. And if you don’t, you have an option to borrow against the deposit. Banks lend up to 90 per cent of the amount you’ve invested in the deposit scheme. The interest charged on the loan is about 1 to 2 per cent over the deposit rate and only for the amount of cash used and not the amount borrowed. And this works out cheaper than any unsecured loan like personal loan or credit card and loan on it.

The earning potential of deposits lies in compounding of interest. That is, reinvesting the principal and the interest earned during the period. This increases the amount you get on maturity, dramatically. To get the maximum returns one should compare fixed deposit schemes from various banks before zeroing in on one. For instance, if you start a cumulative deposit for 9 per cent for a year which compounds quarterly then the effective rate of return is 9.31 per cent. Similarly, if the rate of interest is 10 per cent then the effective rate is 10.38 per cent, higher by over 30 basis points.

Fixed deposits can also be linked to savings accounts of banks in the form of a sweep-in deposits. This gives the benefit of a higher rate of return (in case you have a surplus) and flexibility to use the money when required.

But, how do you know which deposit scheme you should use and when?

Regular saving for a short period (1-2 years) can be done through the recurring deposits. This works like a systematic investment plan (SIP) of mutual funds just that funds don’t assure returns. You deposit a fixed amount every month with the bank for a predetermined rate of return. Recurring deposit rates are same as fixed deposit rates.

Those in the 20-30 age group do not have any liabilities. Hence a longer tenure deposit should work (3 years or more). But, many in this age group are unclear about their future plans when starting work. In that case, they could start with shorter tenures (1-2 years) as it can come handy in case of any emergency.

When in the middle age (35-50 years), you tend to have a built-up capital. Hence, you could park your funds in deposits for 2-3 years for near-term necessities. Like, shorter-term deposits (one year) can help in a medical emergency. But, keep in mind your tax implications.

If you are retired or nearing it, take the longer-tenure deposit route (3 years or more) to ensure you have a sustained quarterly/yearly income with tax benefits. This is also a safe way to preserve the post-retirement corpus.

Flexi deposit schemes works for those unclear about near-term financial needs and yet don’t want to keep their money idle in the savings account. With State Bank of India’s scheme, you need to invest between Rs 5,000 and Rs 50,000 a year for a minimum of five years and a maximum of seven years. The rate of interest will be the same as in case of term deposit.

Bank deposits face interest rate risk. Also, it means a lost opportunity to invest in an instrument that gives higher returns like equities. Also to be looked at is the inflation effect. The real return from deposits is very less or sometimes negative when adjusted with inflation. This is a pain particularly for the retired, and have invested their retirement proceeds to get regular income. Their income may be regular and steady but the value of money goes down in the tenure.

Long-tenure deposits help in absorbing interest-rate shocks, if any. This especially holds true in the present conditions, where rates are likely to start moving down soon, and interest income for those in the highest tax bracket will remain untouched.

Bank fixed deposits are not very tax efficient as the interest income is taxed as per slab. If you fall in the 20 per cent bracket, a deposit scheme offering 9 per cent ends up paying you 7.2 per cent. That’s why banks offer special tax-saving schemes (qualifying under Section 80C of the Income Tax Act for up to Rs 1 lakh) which invest for 5 years. This scheme does not allow partial withdrawal or premature closure, and loan facility. The rate is also slightly lower compared to the shorter tenure ones.

Inspite of the capital protection assurance, work around having a proper asset allocation based on your risk appetite than putting all your money in deposits. Less real return and low tax efficiency eats into your interest earning.

The writer is a freelancer

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