Term Deposits, Functions, Types, Challenges

Term Deposits are fixed-term investment accounts offered by banks where customers deposit a lump sum of money for a specified period at a predetermined interest rate. Also known as Fixed Deposits (FDs), these accounts earn higher interest than savings accounts and are considered safe investment options. The tenure can range from a few days to several years. Premature withdrawal is allowed but usually incurs a penalty. Interest can be paid monthly, quarterly, or at maturity. Term deposits are ideal for risk-averse investors seeking stable returns and capital protection. They are widely used for saving goals and financial planning.

Functions of Term Deposits:

• Capital Preservation

Term deposits provide a secure way to preserve capital by offering a fixed return over a defined tenure. The investment amount remains intact, and there’s no risk of loss, making them ideal for risk-averse investors. Since the amount is locked in, it prevents impulsive spending and helps build financial discipline. Banks are regulated entities, and deposits up to ₹5 lakh are insured by DICGC, further enhancing the safety of term deposits for conservative investors.

• Interest Income Generation

A primary function of term deposits is to generate regular or lump sum interest income. Fixed and recurring deposits offer assured interest rates, which can be received monthly, quarterly, or at maturity. This helps individuals supplement their income, especially retirees or people with idle funds. The compounding of interest over time boosts the total return. Interest rates are predetermined and unaffected by market fluctuations, offering stable and predictable earnings throughout the deposit tenure.

• Encouraging Savings Discipline

Term deposits help promote financial discipline and systematic saving habits. Since funds are locked in for a specific period, investors are encouraged to set aside money and avoid unnecessary withdrawals. Recurring deposits, in particular, foster monthly saving habits, ideal for salaried individuals and students. By committing to a fixed tenure and amount, depositors gradually build a financial corpus that can be used for future goals like education, travel, or emergencies, supporting long-term financial planning.

• Supporting Financial Goals

Term deposits serve as effective tools for goal-based saving. Investors often open FDs or RDs to save for specific financial milestones such as child’s education, marriage, home renovation, or a car purchase. With fixed tenures and guaranteed returns, it becomes easier to calculate the future maturity amount required to meet those goals. This predictability makes term deposits reliable for short- and medium-term planning where capital safety and assured returns are more important than high-risk growth.

• Providing Loan and Overdraft Facility

Banks allow customers to take loans or overdrafts against term deposits, usually up to 90% of the deposit amount. This avoids premature withdrawal and continues to earn interest. The loan carries a lower interest rate than personal loans, as it’s backed by collateral. It is useful during cash flow issues or emergencies, enabling customers to maintain liquidity without breaking the deposit. This function enhances the utility of term deposits by offering both returns and emergency support.

• Wealth Diversification and Low-Risk Investment

Term deposits help diversify an individual’s portfolio by offering a low-risk investment option. While stocks and mutual funds offer high returns with volatility, term deposits offer stability and predictability. Including FDs and RDs in a portfolio reduces overall risk and ensures balanced asset allocation. This is particularly valuable for senior citizens, conservative investors, or those nearing retirement, as it safeguards against market fluctuations and ensures at least part of their wealth is securely parked.

Types of Term Deposits:

• Fixed Deposit (FD)

Fixed Deposit is the most common term deposit where a lump sum is deposited for a fixed tenure at a predetermined interest rate. The maturity period ranges from 7 days to 10 years. Interest can be received periodically or at maturity. It offers higher returns than savings accounts and ensures capital protection. Premature withdrawal is allowed with a penalty. FDs are ideal for conservative investors seeking low-risk and guaranteed returns with flexible investment durations.

• Recurring Deposit (RD)

Recurring Deposit allows individuals to deposit a fixed amount monthly over a specified tenure (typically 6 months to 10 years). Interest is compounded quarterly and paid at maturity. It encourages regular saving habits and is suitable for salaried individuals and students. RDs offer similar interest rates as FDs and are low-risk. Premature withdrawal is permitted but attracts penalties. It is ideal for people with disciplined income streams who wish to build a corpus over time.

• Tax-Saver Fixed Deposit

Tax-Saver FDs are a type of fixed deposit with a lock-in period of 5 years, eligible for tax deduction under Section 80C of the Income Tax Act, up to ₹1.5 lakh per financial year. These deposits do not allow premature withdrawal or loans against the deposit. Interest earned is taxable. They are ideal for individuals seeking both capital safety and tax benefits, though returns are modest and liquidity is limited due to the lock-in.

• Special Term Deposit Scheme

Some banks offer Special Term Deposit Schemes with non-standard tenures such as 444 days, 555 days, etc., with slightly higher interest rates than regular FDs. These are promotional products aimed at attracting deposits during specific periods. They function like regular FDs but may offer higher yield and unique compounding methods. These are suitable for investors who can hold funds for the specified odd term and are looking for better short-term returns than regular FDs.

• Senior Citizens Fixed Deposit

This FD is specifically designed for individuals aged 60 years and above, offering higher interest rates (typically 0.25% to 0.75% more than regular FDs). The tenure ranges from 7 days to 10 years. These deposits support retirement planning and provide a steady income stream. Some banks offer additional benefits like monthly interest payouts, flexible tenures, and higher TDS exemption limits. They are ideal for retirees looking for safe investment with regular income and capital protection.

• Flexi or Sweep-In Deposit

Flexi Deposit or Sweep-In Account combines features of a savings/current account and FD. Excess funds in the savings account are automatically transferred to an FD to earn higher interest. When needed, the FD is automatically broken in multiples to maintain liquidity. This hybrid account provides the dual benefit of liquidity and better returns. It is suitable for those who maintain high balances but want interest earnings without compromising access to funds.

Challenges of Term Deposits:

• Low Liquidity

Term deposits are not easily accessible before maturity, making them less liquid compared to savings or current accounts. If investors need urgent funds, premature withdrawal may be the only option, often subject to penalties or reduced interest rates. This restricts flexibility and may cause inconvenience during emergencies. Therefore, individuals must carefully assess their liquidity needs before locking funds in a term deposit to avoid financial stress or unexpected shortfalls.

• Inflation Risk

The interest earned on term deposits may not always outpace inflation, especially when inflation rates are high. This reduces the real return on investment over time. While term deposits offer capital safety, their fixed returns might lose value when adjusted for inflation. As a result, the purchasing power of the matured amount can decline, making term deposits less suitable for long-term wealth accumulation or retirement planning without additional inflation-proof investment options.

• Fixed Returns

Term deposits offer fixed interest rates, which means investors cannot benefit from rising market rates once the deposit is locked. This becomes a disadvantage during periods of increasing interest rates, as the funds remain tied up at lower yields. Unlike mutual funds or market-linked instruments, term deposits do not provide any scope for capital appreciation. This rigidity in returns can limit an investor’s ability to optimize income from changing market conditions.

• Penalty on Premature Withdrawal

Withdrawing a term deposit before its maturity often attracts penalty charges or lower interest payouts. The penalty amount varies across banks but can significantly reduce the investor’s expected return. This discourages early redemption and may force customers to rely on costlier alternatives like personal loans during financial crises. It’s important to align the deposit’s tenure with foreseeable financial needs to avoid such penalties and ensure maximum benefit from the term deposit.

• Taxability of Interest

Interest earned on term deposits is fully taxable under the head ‘Income from Other Sources.’ If the interest income exceeds ₹40,000 (₹50,000 for senior citizens) in a financial year, Tax Deducted at Source (TDS) is applicable. This reduces the post-tax return and may lower the appeal of term deposits for individuals in higher tax brackets. Investors must consider their tax liabilities and explore tax-saving FDs or alternative instruments for better after-tax gains.

• Limited Wealth Creation

Term deposits are designed for capital preservation, not aggressive growth. Compared to equity or mutual funds, they offer limited wealth creation potential. The fixed nature of returns, absence of compounding benefits beyond the agreed rate, and inflationary pressure all contribute to lower long-term gains. While they are ideal for conservative investors, term deposits may not suit individuals seeking high returns or aiming to build substantial wealth over extended periods.