For many Indians, this may be a common scenario – A salary is earned, deposited in a bank account, and as and when there is a need, it is withdrawn. Yet, there are those who choose to invest their earnings.
And among the investment options, an FD investment is certainly very popular. It offers assured returns and is a very safe investment option. But, have we ever thought about how a Fixed Deposit really works?
Who do banks and financial institutions serve?
Firstly, it is important to understand that the purpose of a financial institution is to serve the borrower. A bank may have a panel of various experts that analyse the projects and companies that come to the bank with a loan request.
Notably, at any point, the bank or financial institution may have a considerable line up of projects that the bank or financial institution can provide a loan for.
How does an FD work?
When an individual deposits money in a Fixed Deposit, these funds can then be made available as a loan from the bank to numerous projects of different companies.
These companies get the loan by agreeing to pay a certain interest rate on it. It is such loans that serve as a financial institution’s main source of income. After deducting certain expenses and profits from what a company pays to the bank, rest of the amount is paid as interest rate on a Fixed Deposit account.
Usually, when a bank is paying around 6% interest on an FD, it may be charging the borrower an interest of 10 to 12%. Herein too, the rates charged by the bank or financial institution may be lower for those companies that are safer in terms of loan repayment capacity. And on the other hand, a riskier investment prospect can involve a higher interest rate being charged.
But your investment in an FD remains secure. How? A company taking a loan from a bank has to put repayment of the bank’s loan on a higher priority than paying the shareholders. A financial institution too has to pay the ones holding an FD before paying their own shareholders. Moreover, a financial institution can give a loan to a company only after having done a thorough risk analysis.
The cost of an FD’s secure nature
There certainly is a price to pay for the secure nature of an FD. Primarily, this in the difference between what someone investing in a company earns vs. what you earn by indirectly investing in that company through an FD.
An investment of say INR 10 lakh for 10-15 years in an FD with 7-8% interest can earn you a return of around INR 20-25 lakh. On the other hand, investing directly in the company may have earned you 1-1.5 crore over the same time period. Thus, the safety of an FD has cost you nearly 80 lakhs. As the value of your investment gets bigger, so does the corresponding loss.
You have to start developing a certain understanding of the market. Not everyone can become a financial whiz and know everything. But you can start with the basics at least and slowly understand the details. With effort and discipline, expertise will surely come.
Moreover, you will have to make an investment plan, have a diverse investment portfolio and stay regularly updated on the market trends. Also, by taking the help of a financial expert you can start to better manage your investments. The costs and effort associated with doing all this can certainly be less than what you may end up losing by investing only in a Fixed Deposit.