The fixed deposits or FDs are considered as one of the safest and popular forms of investment mode amongst the middle-class Indian section. Its distinct feature of guaranteed return on maturity has made most of the investors to park their investment in this scheme.
Apart from this, these FDs do fetch higher interest and returns compared to the normal savings account. During financial distress times, one can always rely on the fixed deposits as it comes in hand instead of opting for a personal loan. The option of a pre-withdrawal facility helps the investors to withdraw funds to meet the emergency needs.
But these fixed deposits do involve risks involved in them. Let's understand those risks in detail.
Usually, a bank fixed deposit or the one offered by the financial institutions do face five types of risks.
- Default Risk
- Liquidity Risk
- Interest Rate Risk
- Reinvestment Risk
- Inflation Risk
The default of repayment of the invested money along with interest amount by a bank is usually rare but it is possible. But as per the new amendment, the deposit money including interest to the tune of up to Rs 5 lakh per person per bank is guaranteed by the Deposit Insurance Credit Guarantee Corporation (DICGC). Any amount over and above Rs 5 lakh per individual is subject to default risk.
The fixed deposits can be easily liquidated, but it comes with a penalty fee. Most of the banks in India do offer pre-maturity withdrawal facility to the investors. But a penalty fee will be levied which has to be borne by the investor for early withdrawal of funds.
In case of 5 - Year Tax Savings Fixed Deposit, the investor cannot withdraw the proceeds before the completion of the said tenure of five years. Though this tax saver scheme offers income tax benefits to the customers, it comes with a drawback.
Interest Rate Risk
The interest rates are subject to change at regular intervals of time. The fixed deposits offered by banks carry the risk of being locked in for a long interval of time at lower interest rates. Thus they will yield a low rate of return.
The declining interest rate scenario over the last few years will leave investors with a tough task whether to go for reinvestment of these fixed deposits or not. The falling interest rate environment will make these FDs which are due to get matured to fetch a lower rate at the time of maturity.
Sometimes, the returns from fixed deposits can be the same as inflation rates or even less than the prevailing inflation rates. It will lead to erosion of wealth of an investor.