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Don’t put all your money in fixed deposits

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The fixed trap.

Most of us think that fixed deposits are a ‘risk free’ source of income. We are trained by our parents to believe that. Right from our childhood, this is one simple investing rule  we learn – If you have a lot of money as fixed deposit , you’re safe! This is the strategy that our grant parents did , now our retired parents do the same and in future,  we too wish that we  want to accumulate a lot of money and put it in bank FD – and be safe.

The reason for this is quite simple – irrespective of what happens in the economy, in the stock markets or in the political environment country, your monthly income at a specific rate is guaranteed. Even if the bank fails, the RBI would immediately step in and save all the depositors and will make sure that you get your money back.

The truth, however is that, you earn money only if your investment can generate a post tax income which is greater than the average combined rate of inflation and tax prevailing in the country you are living. We will explain that:

Let’s take an example: 

Out Friend Mr X  invests 200,000 in fixed deposits for 8% interest and gets 16,000 as interest at the end of year 1.

But effectively, he would get an amount lesser than 16,000.

That’s because of two factors: 1) Income Tax.   2)  Inflation.

Assuming that the bank deducts 10% as tax, Mr. A will get only 14,400.00 as interest.

Now, the second factor that reduces his income is Inflation. The average inflation rate in India is around 8%.That means, his 214,400 is further reduced by 8% in value at the end of year 1.

So Rs 214,400 gets effectively reduced to 198,518.By depositing money for 8% interest, he dint actually earn anything. In fact he lost 1482 from his capital

Hence, if you have all your money in debt instruments like fixed deposits, you’re not safe. Your principal amount would keep reducing in value over time , unless the inflation rate is less. So, the point here is that, you have to look for investment opportunities where you can generate an income that is higher than the combined rate of tax and inflation.

How to check:

Step 1. Multiply the money invest with the rate of interest offered.

Step 2. From the interest amount received in step 1, deduct the applicable tax.

Step 3. Find out the average rate of inflation prevailing in your country (search in Google, it’s just a click away)

Step 4. Apply the rate to the amount received after step 2 and find the present value.
(how to find present value has been already explained in our earlier posts)

Now this post was not to discourage anyone from investing in debt. Debt investments have advantages too. For example, for those who are very weak in risk tolerance, investing in fixed deposits or debts like FDs may be the only way out. The second advantage is that the returns are predictable. Whether it is 10% or 2%, you can calculate the returns in advance and plan something accordingly. So it keeps that anxiety out the way. Third, fixed deposits /debts are the only way to utilize funds lying idle for a very short time. Finally, at a very old age, when you want to stop working or when your life doesn’t permit you to work anymore, the obvious choice is to invest it in fixed deposits.

 

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