A fixed deposit is an agreement to deposit money for a fixed period with a bank that will pay you interest. You can choose to invest for three months, six months, one year or five years. You will receive a higher interest rate for the longer time commitment. You promise to leave all the money, plus the interest, with the bank for the entire term, according to www.thebalance.com.
In effect, you are lending the bank your money in return for interest. The fixed deposit is a promissory note that the bank issues you. That is how banks acquire the cash they need to make loans. The interest you receive is less than the pay earns for lending it out. That is how banks earn a profit. But you earn a higher interest rate than you would for an interest-bearing bank account; that is because you can’t withdraw the funds for the agreed-upon time.
There are three advantages to fixed deposits. First, your funds are safe. The federal government guarantees you will never lose your principal. For that reason, they have less risk than bonds, stocks or other more volatile investments.
Second, they offer higher interest rates than interest-bearing current and savings account. They also offer higher interest rates than other safe investments, such as money-market accounts or money market funds.
You can shop around for the best rate. Small banks will offer better rates because they need the funds. Online-only banks will offer higher rates than brick and mortar banks because their costs are lower.
Fixed deposits have three disadvantages. The main disadvantage is that your money is tied up for the life of the certificate. You pay a penalty if you need to withdraw your money before the term is up.
The second disadvantage is that you could miss out on investment opportunities that occur while your money is tied up. For example, you run the risk that interest rates will go up on other products during your term. If it looks like interest rates are rising, you can get a no-penalty fixed deposit. It allows you to get your money back without charge any time after the first six days. They pay more than a money market, but less than a regular fixed deposit.
The third problem is that fixed deposits don’t pay enough to keep up with the rate of inflation. If you only invest in fixed deposits, you would lose your standard of living over time. The best way to keep ahead of inflation is with stock investing, but that is risky. You could lose total investment. You could get a slightly higher return without risk with treasury inflation protected securities or bonds. Their disadvantage is that you would lose money if there is deflation.
Fixed deposits versus money market accounts
Fixed deposits provide the funds for money market deposit accounts. As a result, their returns are slightly less than what you would get on a fixed deposit. The benefit is you can take your money out at any time without a penalty. The other benefit is that if interest rates go up, you are not locked into a fixed rate of return. Many people prefer this flexibility. Money market deposit accounts are also insured.
Money market mutual funds are select mutual funds that invest in fixed deposits as well as other money market instruments. These are sold by a bank, your broker, or other financial institution. Like a fixed deposit, you can also withdraw funds at any time.
How fixed deposits rates are set
Banks use the funds from issuing fixed deposits to lend, hold in reserves, or spend for their operations. But they have many other choices. Those alternatives determine the interest rates banks pay on fixed deposits.
The nation’s central bank sets that rate. For other needs, banks borrow from each other at the libor rate. Bank pays that rate on one-month, three-month, one-year and five-year loans. They pay more for libor than they pay for fixed deposits. But fixed deposits cost them more because they have to administer them. They can just wire Libor loans to each other. They can also borrow much more than the typical fixed deposits.
Fixed deposit rates will be lower than what they charge their best customers to lend money, known as the prime rate, because banks must make a profit. Their revenue comes from interest paid by borrowers. Their costs are the interest paid to lenders, such as other banks, depositors in money market accounts, and deposits in fixed deposits. Thus, rates paid on fixed deposits will be higher than the fed funds rate, but lower than the prime rate.
Culled from Punch
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