Fixed Deposits: Secure but not perfect - 4 hidden risks to know

Fixed deposit interest rates may be high but beware of certain risks associated with investing in them.

Recently, fixed deposit (FD) interest rates in India have seen an upward trend. Certain banks are now providing rates as high as 8.25% for senior citizens and 7.75% for the general public. Many individuals opt for FDs as a reliable means to secure a consistent income, avoiding the fluctuations often found in stocks or other market-based investments.

Unlike equities, where dividends can vary, FDs provide a stable interest rate that remains unchanged from the time of deposit. This stability enables you to effectively plan your income and budget. A common question arises regarding whether money deposited in bank FDs carries no risk. In truth, there is no completely risk-free investment, and FDs are no different. Nevertheless, the risks associated with FDs are typically viewed as low compared to other investment alternatives. Here are the primary risks to consider:

Default risk: Bank defaults are rare but it’s crucial to acknowledge the risks. In India, deposits are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC) for up to ₹5 lakh per bank account holder. This ensures that even in the event of a bank failure, your funds are protected up to that specified limit. In general, while bank defaults are a concern, there are safeguards in place to reduce the risk. Being mindful of these risks and diversifying your deposits across multiple banks can provide additional protection.

Interest rate risk: Fixed deposits commit you to a fixed interest rate throughout the entire duration. While this stability is advantageous, it also means that if market interest rates increase during your FD term, you do not benefit from these higher rates. Instead, you are bound by the rate you agreed upon initially. This limitation can be frustrating if you observe better returns offered elsewhere.

As the tenure of your FD increases, the impact of interest rate risk grows. A longer lock-in period exposes you to potential missed opportunities if interest rates experience significant increases.

Inflation risk: Inflation diminishes the purchasing power of money invested in FDs. When the FD interest rate lags behind the inflation rate, your returns fail to keep up with the increasing cost of living. Although fixed interest rates in FDs offer stability, they do not adjust for inflation. If inflation outpaces the FD interest rate, you’ll encounter a decrease in real purchasing power.

The interest rate on a fixed deposit serves as a representation of the nominal return. You need to analyze the actual returns to understand the true impact on your finances. This is obtained by subtracting the nominal interest rate from the rate of inflation.

Liquidity risk: For however long you choose to keep the FD, your money is locked in. Early withdrawals frequently carry penalties or yield lower interest payments, which makes it more difficult for you to access money in an emergency.

There are a lot of ways to reduce the risks associated with FD investments. By being aware of these possible risks and taking steps to mitigate them, you will be better equipped to decide whether or not to include FDs in your overall investing strategy.