A Stage 3 investor – one who needs income from her portfolio – needs to meet the three primary criteria of safeguarding capital, providing a predictable income flow and being tax-efficient, together with the added advantage of providing liquidity in an emergency.
The most widely known investment option is, of course, the fixed deposit (FD): an investment where you give someone a sum of money for a fixed period of time and you are promised a fixed interest return over that period of time.
Remember, we’re looking for return OF capital as an imperative, so it’s important that we invest this fixed deposit with someone we can be reasonably sure will return that capital to us. Public sector banks are the safest, as are most private sector banks (with co-operative sector banks meriting some caution – there have unfortunately been a few that have not been well managed and have put their customers’ money at risk – be warned). You’ll probably get the lowest rates of interest here but your money will be the safest.
Next on the safety index would be corporate houses that also accept fixed deposits. There are a number of these and all offer interest rates that tend to be higher than bank deposit rates. It’s tougher to be discerning here but that’s why it’s more important. There are a handful of corporate houses that are trustworthy when it comes to taking your money and giving it back to you and unfortunately there have been way too many shady or fly-by-night ventures that have disappeared with investors’ money over the years.
A good thumb rule is that if the interest rate offered by someone seems too good to be true, it probably is. Untrue, that is. Don’t be greedy and short-sighted. If the market rate (i.e., what a bank is offering) is say, 9%, then a good, well-managed company will offer at most a couple of percentage points above that, say up to 11%. So, if you come across a company offering 15%, be wary. And if you meet one that’s offering 24%, run in the other direction!
Also, keep in mind that the interest rate on offer depends on the period for which you’re parking the money and while often the higher the period, the higher rate, there are occasions when longer term deposits earn lower rates of interest. So, when you’re comparing rates, also compare periods to ensure that your comparisons are valid.
You can opt to park the money so that you get paid the interest periodically (non-cumulative) or get the interest in a lump sum at the end (cumulative). You can arrange to have the deposit automatically renew at the end of the period and you can choose whether to renew the principal alone or the principal with the accumulated interest (for cumulative deposits).
Fixed deposits also tend to be pretty liquid, particularly if parked with a bank – you can usually withdraw them before the period is up, usually at some penalty in terms of interest earned. So, in an emergency, you can draw on them.
If with a bank, you can also set up an emergency overdraft, which you can use in, well, an emergency. A bank will usually allow you an overdraft up to around 80% of your deposit at an interest rate of 2% over the interest rate they’re paying you on your deposit (these numbers may vary from bank to bank). As long as you use this facility only for emergencies or short-term liquidity management (i.e., use this money until some other money comes in), you’ll be fine.
All in all, fixed deposits offer a convenient, safe, easy to understand investment avenue, and the overdraft option is a handy one.
But there are two downsides. The first one is tax. Interest on fixed deposits is largely taxable (there’s a minor exemption for some bank interest, but that’s too minor to be useful). This means that the actual return you get on your deposit is reduced by the tax you pay on it. Also, the places that accept your deposit are obliged to deduct tax at source (usually at 10%) when they pay you your interest. This raises an additional cash flow issue – you don’t actually get the full interest in your hand, you only get the amount left over after tax has been deducted. And if you’re genuinely not taxable you have to wait till the tax department gets around to giving you a refund.
The one way to avoid this tax is to file a 15H or a 15G form declaring that you have no taxable income and so no tax should be deducted at source. Of course, this only works if you really aren’t liable to pay any tax on your annual income, so it’s not a route open to everyone.
The second and more important downside is that your capital never grows (if you opt for a non-cumulative deposit) or at best grows at the interest rate less the tax deducted at source. The problem with this is that this interest rate almost by definition doesn’t match the rate of inflation. So, over time, your expenses go up (because of inflation), but your income doesn’t (because your capital is not growing sufficiently to provide an inflation-beating income), which is a recipe for trouble.
So, by all means, use FDs as one investment option to park some of your money away safely at a rate of return that is explicit and easily calculated. But don’t make that your only option.