Investing in fixed deposits: Beware of these risks you may face

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© Faizan Javed Investing in fixed deposits: Beware of these risks you may face

Among the debt instrument class, a fixed deposit (FD) is usually the secured investment path solely because you know what you are signing up for. You invest an amount for a fixed rate of return which is known to you beforehand. You also know the period of time which you are investing, so that is fixed too.

Some investors, especially conservative ones, prefer these because FDs are not linked to the market, so there is no volatility involved. You need a savings account with a bank to start an FD. Some banks also allow opening without a savings account.

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Five risks you have to be cautious of:

Liquidity risk: Fixed Deposits (FDs) can be easily liquidated, i.e. prior to the maturity date one can break his/her FD. Though, a penalty may be levied and the penalty amount varies from one bank to another. In case of tax-saving FDs, a variation of FDs, you can withdraw before the completion of the 5-year tenure.

Default risk: Bank defaults are rare but possible. However, deposit amount including interest of up to Rs 5 lakh per person per bank account is guaranteed and secured by the Deposit Insurance and Credit Guarantee Corporation (DICGC) in case of such a mishap and any amount over that is exposed to default risk.

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Inflation risk: FD returns at times can be around the same as inflation or even lower, leading to wealth erosion for the investor as the net value comes down to nothing, post accounting for inflation. There is no indexation provision.

Interest rate risk: These come with a 5-year lockin period. Bank FDs carry the risk of being locked in for a long tenure at a low rate of return. Most banks have been slashing rates on their FDs for a while now. If you are a fixed income investor, basically relying on the interest income from an FD, you will have to bear the pain.

Reinvestment risk: In a falling interest rate environment, FDs that are due to mature soon and come under the cumulative option, i.e. those where the interest due to you upon maturity will get reinvested, are bound to get offered a lower rate at the time of maturity, or less money in your hands.