Why a fixed deposit may not be your best friend.

Primarily due to safety and partially due to lack of understanding of better options, a lot of the savings from Indian households finds its way into fixed deposits with banks/Post office.

While there is nothing wrong with it, it certainly may not be your best friend when it comes to long term money management. Here's why-

1. Average returns

Currently the interest rates are not going through a big spike and typical bank Fixed Deposits are fetching anything between 7-8% per annum for longer durations.

But when banks like Kotak, Yes Bank and DBS are offering in excess of 6% on savings bank accounts, the question arises - is it worth locking in your funds to get 1% extra per annum? It translates to about Rs. 400 per month extra on a deposit of 5 lakhs. Does it make a significant difference?

2. Inflation positive?

The average inflation in India over the last 10 years has been in excess of 7% p.a.

It implies that an item costing 100 in 1 year is costing 107 the next year, and F.D returns are just about managing to top this, meaning it just exceeds inflation by about 1%. Certainly it's not a tool for long term wealth creation.

3. Not necessarily safe

Here's a data that will leave you stunned. More than 500 banks in India have failed since Independence. That's a whopping number no doubt!

Most of these were in the years after independence, but even in the last 20 years nearly 20 small and big banks have pulled their shutters down, only being salvaged by mergers with some other larger banks.

Besides an individual's deposits are secured only to the extent of 1 lakh. So any amount in excess of it has no guarantee per se.

4. Tax inefficient

The returns from a fixed deposit are to be added to your taxable income and taxes are to be paid on it. While it may be suitable for a person who is below the taxable limit, it is certainly most inefficient for individuals in the 20-30% tax brackets. Plus if your interest is above 10000 a year, tax is deducted at source unless form 15G or 15H is submitted to the bank.

The summary of these points indicates returns just close to inflation post tax, which means you are actually not earning anything, and instead just maintaining your money. So what else can an investor opt for?

Options like Equity, Real Estate, Commodities come with their own elements of risk. But without deviating from fixed income products, there are several other options which may be considered for an interest income.

a) Company Fixed Deposits/ Bonds

Yields are much better than F.D, plus they are mandatory to be rated. The lower rated papers give better yields. However one should opt for an A rated paper at the least, and preferably a mix of AA and AAA rated instruments. And they are spread over various maturities.

b) Government Bonds

Certainly there is no element of credit risk here, which also implies lower yields than corporate bonds. Normally higher maturity bonds will have higher rate of return.

c) Debt Funds by Mutual Funds

Comprising mainly of longer duration debt funds, and liquid funds.

While liquid funds are deemed safe and returns are higher than most savings bank accounts, debt funds come with an element of risk.

Rather than credit risk, it is an interest rate risk which is prominent here. Meaning based on the current yields in the market, the market value of the papers will fluctuate either way. And because unlike most other debt products, there is continuous inflow and outflow in these funds, there has to be purchases and sales made on a regular basis making it very difficult to give any consistent returns.

d) Fixed Maturity Plans by Mutual Funds

A much more preferred debt product by fund houses is a fixed maturity plan. As the name suggests, they have a fixed maturity for which the fund will operate. It's a close ended product which holds commercial papers of various companies and govt bonds in its portfolio. So the returns are almost pre fixed and since the fund doesn't have to worry about inflows and outflows, they can deliver a very stable return. They score over the above mentioned options due to better diversification.

e) Post office savings products

Comprising mainly of PPF, NSC and Senior Citizens savings scheme apart from few others, these products are completely safe, and most of them offer some tax benefit as well. Returns though fixed are certainly not bad. Their only undoing is the longer lock-ins that need to be maintained, which means reduced or no liquidity.

While there are few other alternatives available to invest, these 5 options certainly take the lion's share. However there are differences among each of them and merits and demerits associated with the style of products.

So, if one has to pick a bouquet of products from these and build a portfolio, complete knowledge of returns, risk, duration and taxation need to be understood, which is the job of a financial advisor.

Hence, the first step would be to partner with the right financial advisor to aid in your journey to manage your money better. Start by choosing wisely.