Titanic, the largest ship of its time, was considered unsinkable. But that myth was dispelled on 15th April 1912 when the Titanic sank after hitting an iceberg in the North Atlantic ocean.
Something similar happened to bank fixed deposits too. Once considered as a very safe instrument for investment, the myth of safety surrounding bank deposits was busted after the PMC Bank scam came to light in 2019, forcing RBI to step in. The cap on withdrawal of deposit money in the aftermath left many of the PMC Bank\’s left many of PMC\’s over 900,000 depositors in great difficulty.
A year later, the withdrawal cap now raised to Rs.1,00,000 has forced many investors to resort to borrowing money and cut down on necessary expenses despite having the money in PMC Bank deposits.
PMC Bank is not just a one-off case. In March 2020, the RBI imposed a cap of 50,000 rupees on withdrawals from Yes Bank, which was at that point, India\’s fifth-largest bank in terms of assets, after its finances deteriorated due to mismanagement.
The withdrawal curbs were subsequently lifted after SBI announced a Rs 7,250-crore fund infusion into the crippled Yes Bank as a part of a Reserve Bank-mandated rescue plan.
Yes Bank depositors were lucky. However, there have been instances where investors have lost money after the bank where they deposited money went bust. According to a report by Moneylife, 165 cooperative banks have been shut down in Maharashtra alone in the past 30 years.
To protect the interest of depositors, in her Budget speech on 1st February, 2020, Finance Minister Nirmala Sitharaman announced that \”Deposit Insurance and Credit Guarantee Corporation (DICGC) is permitted to increase deposit insurance coverage from Rs 1 lakh to Rs 5 lakh.\”
While this increase in deposit insurance was considered a significant move, it only addressed half the problem. Firstly, the deposit insurance is payable to the investors only if the banking license of the Bank is terminated and not in the case where the banking license is suspended like what happened in the case of CKP Co-operative Bank in May 2014 where depositors are yet to receive their dues.
Secondly, deposit insurance of 5 lakh will not cover the losses of investors who hold significantly higher amounts in a deposit. In comparison, the deposit insurance payable in the event of bank failures in countries like USA, UK, Russia and Brazil stand much higher covering up to $250,000, £85,000 and R$250,000 per depositor respectively.
Now let’s take a look at the reasons why investing in bank fixed deposits can never create wealth.
Inflation reduces the real rate of return
If you think you have made a smart move by steering clear of market-related risks by investing in fixed deposits which generate a guaranteed return of 5.5 to 6% per year, think again. High inflation reduces the real rate of returns generated by your investment in bank fixed deposits.
To help better understand this, let’s take a look at an example.
An investment of Rs.1,00,000 in a bank fixed deposit at 6% p.a would generate a yearly return of Rs.6000. Considering the current rate of inflation between 6-7%, the real rate of returns that you get from your investment in fixed deposit is zero or negative. With inflation will eating away all the interest earned, the actual value of the interest earned by you from the bank deposits will be eroded.
Interest earned from fixed deposits is taxable
Interest earned on fixed deposits is subject to income tax as it is classified as \’income from other sources\’. Hence, the income is added to an individual’s total income, and the tax liability is applicable as per their income tax slab. For example, your income tax slab is 30% your tax liability on your total income including interest from bank deposits will be calculated at 30%.
Pre-mature closure of fixed deposits attract a penalty
Most banks levy a penalty ranging from 0.5% – 1% on pre-mature closure of deposits. In some cases, the applicable interest rate may also change accordingly.
For example, if you have invested five lacs in a fixed deposit scheme for five years at an interest rate of 6%, but if you decide to close the deposit after one year, the interest rate applicable on your deposit would be a lower one. Apart from it, a penalty of 0.5 to 1% on pre-mature closure would further reduce the return generated.
Bottom line – Is it worth investing in fixed deposits?
Fixed deposit rates have been on the decline over the last few years. As our economy grows, additional rate cuts will be inevitable, reducing the returns generated by fixed deposits further. It is ok to invest in fixed deposits for the short term. However, it is not the ideal investment if you are investing for long term financial goals like buying a house, planning for retirement or children’s higher education or marriage. The cons of investing fixed deposits far outweigh the benefits of investing in it.
To create wealth, equity investment can be your best bet. Equity has not only beaten the returns of all other asset classes hands down consistently but is also the only investment which can beat rising inflation. Check out how much more you would have gained by investing in our model portfolio as compared to an investment in bank fixed deposit over a 5 year period here.