Drop in Deposit Rates – Implications for FDs

Introduction

This might sound like a folk tale, but once upon a time, fixed deposit interest rates were as high as 8-9%. Those were the merry old days of FDs when people flocked to them and invested heavily. If you were a senior citizen, you could get a higher-than-9-percent interest rate as well on your fixed deposit. 8-9% guaranteed returns were understandably a big deal for investors. But those days are far behind us now.  

For the past couple of years, deposit rates have been falling consistently. Today, the interest rates available on fixed deposits with popular banks range from approximately 5% to 7.5%. This means that if you invest now in fixed deposits, you will be earning low returns. Some financial institutions to offer an 8% interest rate on fixed deposits, but they are few and far in between.

Why have FDs become a secondary investment option?

Unlike before, fixed deposits have today become extremely unattractive investment options in this low deposit rate scenario. And even more so when you take the income tax on the interested earned into account. Interest from fixed deposits is subject to tax as per the investor’s income tax slab.

The interest income you earn has to be added to your annual taxable income and tax will be paid on it as per the slab you fall under. This tax eats away the interest earned and reduces it dramatically. The following table shows your income tax reduces the effective rate of interest on FDs.  

As the table shows, the higher your tax bracket, the lesser your post-tax interest income from fixed deposits will be. FDs might still make some sense for someone in the lower tax bracket, who wish to earn guaranteed returns. But for investors in the 20% and 30% tax brackets, fixed deposits will not give them meaningful returns.  

Why are FD rates declining?

One of the reasons for FD rates declining can be that banks today have increased liquidity due to the rise in cash deposits by customers. Post the government’s demonetization move, many banks received huge cash deposits. According to reports, the Reserve Bank of India (RBI), and other banks have received deposits in excess of Rs 5.11 trillion since the announcement.

Since a huge chunk of these deposits has been kept in savings accounts, the banks have to pay interest at a minimum of 4% interest to these account holders. By cutting the rates of FD accounts, they have tried to balance the cash outflow. An influx of cash in such large volumes also means that the banks have more funds to lend to their customers.

Hence, a lowering of deposit rates is usually accompanied by a lowering of the lending rate. With the FD rates being cut, the MCLR (marginal cost of funds based lending rate) has also come down. This is good news for those looking to borrow money from the banks. The average investor whose only aim is to save money and earn more from the investment is however left in the lurch due to this.

What are the other options besides FDs that you can invest in?

So, what should you do? Where should you invest to earn meaningful returns and grow wealth? The answer is mutual funds. There are equity mutual funds and debt mutual funds that you can choose to invest in, depending on your risk profile and investment goals. The advantages of investing in mutual funds are many:

Higher, tax-efficient returns

Mutual funds are not only capable of earning higher returns than FDs, the returns are also more tax-friendly. While long-term gains from equity funds are entirely tax-free, those from debt funds are subject to 20% tax after indexation, which helps in greatly reducing the tax outgo

Liquidity

Unlike FDs, mutual funds don’t have a lock-in period (the exception being ELSS funds). You can redeem your mutual fund investments, partly or fully, any time you want

Flexibility

You’re never stuck with a mutual fund. If the fund you have invested in is underperforming, you can stop investing in it and switch to another fund

It is for all of these reasons that mutual funds are believed to be better investment options than fixed deposits. Deposit rates are not expected to go up any time soon, which makes the case for mutual funds even more compelling.