If wealth creation is your goal, you need to look beyond FDs because they are highly tax-inefficient and provide a low rate of return.

The falling interest rates on fixed deposits (FDs) following the recent rate cuts by the RBI have made them an unattractive investment option for a majority of investors. In fact, lots of leading banks — including the State Bank of India and HDFC Bank — are currently offering interest rates between 4 per cent and 6 per cent on their fixed deposits, depending on the investment tenure, which has made them at par with the savings account interest rates offered by many banks — offering very little incentive to investors to park their money in FDs.

However, if you are a risk-averse investor or a senior citizen and can’t think about putting your money in a saving instrument other than an FD, then there is no need to get disappointed. Even if you are not risk-averse and are looking for better returns, thankfully, you can still get better options in FD itself. However, before that, you need to understand the nitty-gritty of interest rates.

In fact, banks need deposits and deposits help banks to provide loans. Therefore, to be able to provide new loans, banks need to keep attracting fresh deposits. To attract fresh deposits, some banks will provide you more interest than other bigger or established banks.

“It needs to be understood that all forms of savings and investments carry risks. To get higher rewards, you must take higher risks. Risks are lower at the bigger and more established banks for a variety of reasons such as low NPAs. Therefore, due to lower risks, those banks provide lower returns. If your bank were to undergo a moratorium or corrective action, you may not be able to withdraw your deposits for a period of time determined by the RBI. In the history of modern India, no customer has lost his deposit with an Indian bank,” says Adhil Shetty, CEO, Bankbazaar.com.

How and where to get higher returns on FDs

It is true that a majority of banks are currently offering lower interest rates on their FDs. However, that is not the case with all the banks. In fact, some of them are still offering interest rates as high as 9 per cent.

“The highest FD rates offered by some of the small finance banks and a few private sector banks are about 200-300 bps higher than those offered by PSU banks and most private sector banks. Hence, those wishing to earn higher interest rates on their bank fixed deposits can consider opening FDs with such small finance and private sector banks,” says Sahil Arora, Director & Group Head-Investments, Paisabazaar.com.

How safe are FDs in small finance banks and private banks

It must be understood that the RBI has granted the status of Scheduled Banks to these small finance banks, which brings their depositors under the umbrella of deposit insurance program of DICGC, an RBI subsidiary. This insurance program protects bank depositors for deposits of up to Rs 5 lakh in each scheduled bank in case a scheduled bank fails to pay back its depositors. The cumulative deposits, including those held in savings, current, fixed and recurring deposits, are considered while arriving at the Rs 5 lakh cap.

Hence, “maintaining bank deposits of up to Rs 5 lakh in each of these small finance banks is as safe as keeping deposits with public sector banks and major private sector banks. To reduce the deposit risk to the extent possible, bank depositors can spread their fixed deposits across multiple banks offering high-yield FDs in such a way that their cumulative deposits in each of those banks do not cross the Rs 5 lakh cap,” says Arora.

Moreover, you can split your deposits across multiple banks. “As with investments, it isn’t ideal to have all your deposits at one bank. You can therefore split your deposits across multiple banks with good track records. If you wanted to take higher risks for higher returns, you could go with smaller banks, company deposits, small savings schemes, government bonds or even liquid mutual funds after a thorough evaluation of risks, lock-ins and any applicable charges,” suggests Shetty.

How to evaluate FD returns

It’s not easy to evaluate FD returns over the long-term because the returns are fully taxable as per your slab rate unless you’re a senior citizen in which case you can get Rs 50,000 from deposit interest tax-free. Also, interest is taxed whether or not you redeem your FD. Therefore, for practical purposes, you must only look at post-tax returns from your FD.

For instance, if you were a 30-year-old investing in a 7 per cent FD, it would take approximately 10 years and a few months to double your principal, assuming no taxation. However, if you were in the 30 per cent slab, a 7 per cent FD is returning only 4.2 per cent to you. So effectively, your money will double in 17 years assuming a constant rate of return. This is highly unattractive from an investment point of view.

Therefore, “if wealth creation is your goal, you need to look beyond FDs because they are highly tax-inefficient and provide a low rate of return. Small investors are better off investing through suitable mutual fund schemes or even government-backed schemes such as EPF and PPF, which provide moderately high tax-free and guaranteed returns,” informs Shetty.

Those with higher risk appetite can consider ultra-short, short and low-duration debt funds to park their money for their short-term goals. “These debt funds usually offer higher returns than bank FDs and are also more tax-efficient than FDs for investors in the 20 per cent and 30 per cent tax slabs with investment horizons exceeding 3 years,” says Arora.

However, while selecting from these funds, avoid those having significant exposure to non-AAA category bonds and other debt papers.