In line with a broader decline in interest rates, banks have been consistently lowering interest rates on fixed deposits (FDs) and savings account deposits.
Why FD rates are declining
For the last 5 years, the government is consciously targeting a low rate of inflation. But what does inflation have to do with rates of interest on FDs?
Let’s use a very simple example to explain this. Say, the rate of inflation is 8 percent per annum and you earn 8 percent per annum on your FD. Your money is not really growing. And there is no incentive to save it in the bank.
On the other hand, if the rate of inflation is 4 percent per annum and you’re still getting 8 percent per annum on your fixed deposit, the incentive to spend or invest in avenues that encourage economic activity and growth is very low. When people don’t spend, it it can lead to deflation and affect the long term health of the economy and your investment.
This is one reason, the rate of return on fixed deposits and similar instruments will always be close to the rate of inflation in dynamic, healthy economies – usually, a percentage point on two higher than the rate of inflation. This gives people an incentive to save, but at the same time, also encourages robust economic activity in other sectors.
There is no doubt that interest rates on FDs are heading even lower, unless the rate of inflation starts to rise. And the government is not going to allow the latter to happen.
How to invest in such a scenario
For savers, pensioners, and traditional investors, the falling rates of interest on FDs can sound like very bad news and a problem with no comforting solution. In such a scenario, if you still wish to invest in FDs, you should do it immediately and you must lock these funds for a longer term of 3-5 years.
But before that, do factor in the real rate of return as well as the post-tax return in these cases to decide where to invest. A simple calculation will demonstrate that your money will not return more than a single percent per annum if you only invest in FDs. What is the alternative?
Alternatively, investors are advised to work with an expert advisor who can help you arrive at a prudent asset allocation formula comprising FDs, equity, and debt, which can offer you safety, the convenience of liquidity, stable returns, and real advantages over parking all your liquid funds in an FD or high risk investments.
Happily, this optimum asset allocation balance is not at all difficult to achieve. We have done it successfully for many of our clients and we can do it for you. Talk to us and we’ll show you a way forward that will help you solve this seemingly Catch-22 situation. Welcome.