Monday, June 13, 2005

Fixed deposits - Are they really worth it?

I have had a very strong view on putting money in fixed deposits(FDs) - CDs for you Americans :-) and why should we go about doing them. FDs in India has been the first love of retail investor for a long time. They have appear in so many shapes and forms to satisfy the investor's palette - all the way from automatic credit from your savings accounts to FDs to large and small companies themselves offering fixed deposits albeit at a higher rate. The big buffet of options exists I believe simply because fixed deposits are the apple of the eye for the retail investor. So let me take my stand here - I don't like fixed deposits! Why ? Today's interest rates are in the 5-6% range, The returns are 100% taxable since the days of section 80CCC are gone. Every paise that the institution pays you is taxable and so they will eventually have TDS before you lay your hands on the money. So effective return would be in the 3-4% rate. This is obviously less than today's inflation so net result, your money is slowly decaying away. So how do you handle this one may ask? The answer is basically many fold but the underlying philosophy for FDs which I am elaborating below should be your checklist for FD creation.

  • Philosophy 1: Quick access to money for emergencies : One of the key principles of creating an FD is the fact that we need quick access to money for emergencies. So much of money does one need for quick access? If you have a formula for it, great otherwise a 3 month salary would be a good yardstick to use. Anything beyond that in a FD would be underutilized funds.

  • Philosophy 2: Safe and secure returns : This is a bit of a misnomer. If you had followed the logic in the first paragraph, there is no " real return" from a FD post inflation. At best you can feel that your money has not vanished but it is still around. A lot of people found out this is not true during the days when companies that offered fixed deposit vanished overnight.

  • philosophy 3: Temporary parking space of excess cash:A lot of people park excess cash in FDs for short periods as a temporary parking space until they find better investment opportunities. This is a good practice since the returns from a savings account is a lot less than what at 3 - 6 month FD can give you. Interestingly there are new and better avenues to park cash.

Now that we have reviewed what the primary goals for having an FD are, let us explore what are the options available to satisfy these goals to better manage our money.

  • Philosophy 1: Quick access to money for emergencies : To have quick access to cash (< 8 hours), there are very few options available in the market other than a fixed deposit linked savings account. Most banks have such accounts where the money is transparently swept into a FD from the savings account until you attempt to withdraw the money. At that point in time the FDs are "broken" to handle the request. Having said that FDs are the traditional option here, there are a few other options that one can look at to get better benefit. Credit cards provide access to reasonably large sum of money without physically having money available until the next billing cycle. Thus make your emergency payment through a credit card and then when it is time to pay those credit card bills (typically within the month) you access your funds from other sources and pay the card off.

  • Philosophy 2:Safe and Secure Returns : In today's world this is hard to come by but there are various options out there that can provide this option for your money with reasonably higher return than the FD. The post office monthly income scheme (POMIS) is a good option here - it is guaranteed by the government so it is as safe as it can be. it pays 8% returns with 10% additional maturity bonus thus a higher effective rate than the average FD. In terms of liquidity, it does not score well - it does allow encashment after 1 year but the penalty clause of 5% of principal is pretty high. Investors have to wait for 3 years if they wish to close without penalty.
    Investors who are able to digest slightly higher risks can look at debt mutual funds. They provide good liquidity and sometimes very good returns but these instruments are fundamentally more risky than a government backed investment schemes

  • Philosophy 3: Temporary parking of excess cash : If you are one of those fortunate souls that has excess money that should be temporarily parked, you should explore the following options - Liquid mutual funds with their typically better returns than FDs will offer a good parking space for cash. They are highly liquid (you will get your money in a couple of days) and unlike a few FDs, there wont by any clauses for sudden exit. They thrive on the ability to provide parking space for large amounts of cash.

  • With this we have explored various options for money management beyond Fixed deposits. Hope you folks get into active money management beyond FDs through the various routes mentioned here. Do send in comments and feedback if you have other means/options of managing your funds.


Anonymous said...

Good one..keep it up. Looking for some serious depth in other areas like MF. One other point is that the PMIS and the PPF all have caps..which are set for the 1980/90s income levels rather than the inflated INR levels of today. Ideally, these caps should be tripled going by current things in India.
Kalyam,Houston US

payday said...
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Vinod said...

Ok Vivek.....if not FD's what then? Will any of your next posts deal with the alternatives?

Amit said...

Hi Vivek,

Just stumbled across your blog (it's linked to CVRK's blog) and was quite impressed with the content - enough to add a link to it from mine! :-)

Post office MIS is actually an excellent option but it has a cap on investment (300,000 for individuals and 600,000 for joint account holders I think) and hence can't be used beyond a point. Further, the interest is paid out in the form of monthly income, whereas what one would ideally want is for it to compound. The only way to do this through MIS is to also open a post office recurring deposit to which the interest is credited. Messy!

Will read your other posts now. Keep blogging.

Anonymous said...

liked ur blog!i like they way u put everything down in 'real' english, and not finance lingo!