Bank Fixed Deposits (FDs) have been among the most popular and trusted investments of the Indian middle-class investor. It has gained credibility due to 4 reasons:

  • It is provided by banks; hence it is considered a safe investment.
  • It has a fixed rate of interest.
  • Its features are easy to understand.
  • It is easily to open for anyone who has a bank account.

Various banks have different interest rates. Most of them range between 7-9 percent pre-tax. For someone falling in the highest tax bracket, this would reduce to 4-6% for non-tax-free FDs.

So, what would you have actually gained? Nothing! In fact, you would have lost. Your capital would have eroded over the tenure of the FD. This is because our calculations of interest rates generally do not take into account the inflation levels. In a developing country like India, inflation levels are generally between 7-8%, and any investment should aim to provide returns after inflation accounting in the least. A bank FD will not be able to generate any real returns, or even negative returns, if you consider tax and inflation.

Apart from losing out on returns, there is one more loss for the investor. That is, the opportunity cost of the capital set aside in FDs. You put away your money for 3-5 years, foregoing liquidity, when the same money could be employed elsewhere to give much higher returns. There are a number of debt instruments that provide tax-free returns in the hands of the investors, such as Public Provident Fund, National Saving Certificates, National Pension Schemes, etc. and equity schemes such as ELSS where the capital is also tax free. Regular equity schemes have no lock-in, but employing your money for 3-5 years in a good equity scheme will mostly generate returns in the range of 10-15%, which attracts a capital gains tax instead of tax as per slab rate.

Example:

Let us see how investing in FDs can make you lose money. We are taking a 1 lakh investment in FDs for 1 year with 3 interest rates – 8.75%, 9.25% and 10%, with quarterly compounding. Inflation is taken as 7.5%.

 

@ 8.75% @ 9.25% @ 10%
Interest Annual Yield After Inflation Interest Annual Yield After Inflation Interest Annual Yield After Inflation
Maturity amount ₹9041 9.04% 1.54% ₹9576 9.58% 2.08% ₹10,381 10.38% 2.88%
After tax 10.3% ₹8110 8.11% 0.61% ₹8590 8.59% 1.09% ₹9,312 9.31% 1.81%
After tax 20.6% ₹7179 7.18% -0.32% ₹7603 7.6% 0.1% ₹8,243 8.24% 0.74%
After tax 30.9% ₹6248 6.25% -1.25% ₹6617 6.62% -0.88% ₹7173 7.17% -0.33%

Thus, we can see that for an investor in the higher tax bracket, there is a loss in investing in FD, while for even in the lower brackets, there is no significant return.