Fixed deposits, also known as term deposits, are similar to certificates of deposit in that they are a combination of a savings account and an investment vehicle. When a person purchases a fixed deposit, they deposit money into a bank and receive interest payments in return. The interest rates paid on fixed deposits are typically higher than those paid on regular savings accounts.
Like certificates of deposit, fixed deposits have a predetermined term or maturity date. They can range in duration from a few months to several years; and at the end of the term, the depositor receives the principal amount and interest earned. If the depositor wants to withdraw the funds before the maturity date, the bank may impose a penalty or sacrifice a portion of the interest earned.
Some banks may automatically reinvest the principal and interest earned into a new fixed deposit upon maturity, unless the depositor requests otherwise. Fixed deposits are a popular investment option for individuals who want to earn a higher rate of return than a regular savings account while minimising risk.
While certificates of deposit (CDs), also known as Fixed Deposits, are generally considered low-risk investments, there are still some risks associated with them that could result in a loss. Here are a few key risks to consider:
- Interest rate risk: CDs offer fixed interest rates for a specific term. If interest rates rise significantly after purchasing a CD, the locked-in rate may become less competitive compared to prevailing rates. In such cases, individuals may miss out on the opportunity to earn higher returns available in the market.
- Inflation risk: CDs typically provide modest returns, and if the rate of inflation exceeds the interest rate earned on a CD, the purchasing power of the invested funds may erode over time. In other words, the real value of the investment may decrease due to the rising cost of goods and services.
- Early withdrawal penalties: CDs have withdrawal restrictions, and if individuals need to access their funds before the CD reaches maturity, they may face penalties. The penalty amount varies depending on the terms set by the financial institution. These penalties can result in a reduction of the interest earned or, in some cases, even a portion of the principal.
- Opportunity cost: By investing funds in a CD, individuals commit their money for a fixed period. This means they may miss out on other investment opportunities that could potentially provide higher returns. If other investments perform better during the CD term, the individual may experience an opportunity cost by not allocating their funds elsewhere.
- Default risk: While CDs offered by banks are typically backed by Deposit Protection Corporation, it’s important to consider the financial health and stability of the issuing institution. If the bank fails and is unable to honour its obligations, there could be a risk of losing the principal amount invested. However, as long as individuals stay within the Deposit Protection Corporation insurance limits, their deposits are protected up to the maximum insured amount.
It’s crucial for individuals to carefully evaluate their investment objectives, risk tolerance, and financial goals before investing in CDs. Considering the potential risks and comparing offerings from different financial institutions can help individuals make informed decisions and minimise the likelihood of experiencing a loss.