This is the fourth article in a series of articles exploring the main places to keep your savings for maximum benefit according to the reasons you are saving for.
Next, we looked at a regular bank savings account and discussed whether it is a good enough account to keep your savings and the purposes for which it is most appropriate.
Today, we shift gears to a bigger brother to the regular savings account - that is the fixed deposit account, also referred to as the Certificate of Deposit (CoD).
Fixed Deposits are investments in which funds placed are not readily available to the investor before the time agreed (tenure) for the deposit has elapsed. In Kenya, they can be for as short as just one month to several years depending on the saver’s preferences. Other terms you can use to refer to them are time deposits or term deposits.
In exchange for higher interest rates than regular savings accounts, you have to commit to keeping your money in the financial institution of your choice for a certain agreed amount of time.
The institution then agrees to give you more interest on your money than what you would have gotten from a savings account. You will get back a higher annual percentage yield (APY) on the money you’ve deposited since the institution knows that it can use your funds for longer-term investments like issuing out loans and you will not come back asking for any sooner than the agreed period.
It is like loaning a bank your money but they pay it all back with some interest in the end. These returns are usually higher when the funds are invested for a longer period.
For example, an investor would earn a higher interest for keeping the funds for a year than what they would get for a month. But this does not automatically translate for very long periods. You may find that very long-term time deposits have less attractive interest rates as compared to a middle term time deposits. This is because banks do not want to commit to guarantee high returns to account holders for long periods and risk losing to changing market forces.
When the time lapses, the investor can choose to either have their money returned to them or roll over the investment.
However, not everything goes as planned and the investor may choose to withdraw their funds a little earlier before the fixed deposit matures.
If they do this, the bank is obligated to give back the funds in the time deposits but they get charged a penalty for that.
Often the investor forfeits the anticipated interest amount that would have accrued had they waited until the end of the deposit tenure.
If you choose to invest fixed-time deposits, it is important to consider how much funds you have idle and for what time can you operate without needing the money so you can make an informed decision on whether to invest with fixed deposits or not and on what terms.
Security is relatively one of the appealing aspects of this account. Fixed deposit accounts are relatively risk free save for the relatively unlikely event of bank failure. Even in the event of bank failure, depositors in Kenya are insured by the Kenya Deposit Insurance Corporation
With this product, there is a wide range of tenure options for the investor to choose from so they can employ a strategy that best aligns with their needs. An investor may decide to go with a long-term or short-term deposit tenure depending on their financial situation. Long-term time deposits yield much more than a short-term one. But short-term one can also yield more than if stored in a regular savings account.
It is important to seriously think about the tenure you choose to minimise the possibility of needing to withdraw from the account before the period lapses - which could potentially attract a penalty and loss of accumulated interest.
Fixed Deposits generally have better interest rates compared to savings accounts. It is especially important given one of the considerations when comparing interest rates is the ability to beat inflation and, at the very least, maintain the purchasing power of the money you are saving.
Most fixed deposit accounts will offer interest rates above the annual inflation rate, which in 2021 was about 5.4%. As such, when compared to savings accounts that start at about 0.5% in Kenya to a high of 8%, makes them more attractive for those who have money they can afford to stash away for several months without needing it.
Fixed deposits offer definite returns, which is also its reputed feature. This is stated according to the tenure you choose. You have all the information regarding what the exact worth of your investment will be at the end of the term. With guaranteed return, fixed deposits are not affected by market-based surprises that often occur in the stock markets. As such fixed deposits are popular with risk averse investors.
One important advantage fixed deposits have over a regular bank savings account is that you are allowed to borrow against the deposited funds. In Kenya, some banks will allow you to borrow up to 95% of the funds in the fixed deposit account.
So, instead of withdrawing your money and risk losing your interest and paying a penalty, in the event that you need a quick cash injection, you can opt to borrow against your fixed deposit and maintain your savings.
Of course, this may not work for everyone in every situation, but it is a great option to have.
Although safe, secure and predictable it isn’t suitable for everyone such as those who would rather be able to withdraw their money at a moment's notice or those who wish for higher return rates on their money. Here are some drawbacks:
Even though the interest rates on fixed deposits are higher than those of savings accounts, they are too low compared to riskier options such as stocks.
As such, if you want higher returns than fixed deposits offer, it is time to consider riskier options such as trading stocks, real estate and gold among others.
Term deposits are, generally, not impermeable to the effects of inflation. When inflation increases, a common government monetary policy response is to increase interest rates. The interest payments from the existing fixed-income assets become less competitive compared to the newer higher rate fixed-income vehicles.
Prices of the existing fixed-income instruments will fall. This is otherwise saying that, there’s an inverse relationship between fixed-income asset prices and interest rates.
With a fixed deposit account you will have to stash your money away until the end of the term or maturity. You generally should not withdraw money from your account as is practiced with saving accounts. Because of this condition, funds invested in them are not considered liquid. If the saver withdraws money before the end of the term they would have to pay a penalty.
There are two types of fixed deposit account; cumulative fixed deposits reinvest the interest earned on the interest compounding the returns for the account holder while non-cumulative fixed deposits pay out the interest earned every year to the account holder.
While the cumulative fixed deposits sound great, especially due to the power of compounding, an investor who is investing money in this account will face reinvestment risks.
If the interest rates in the market are falling, fixed deposits that are reinvesting will be offered at a lower rate.
Tax payment is also another factor. If a fixed deposit offers a low interest rate to an investor the tax imposed on the returns decreases the returns further to a lower figure.
Interest earned on a fixed deposit account in Kenya is subject to a 15% calculated on a per annum basis.
You need to keep your savings goals in mind while considering going for term deposits. The time-frame you have for achieving your goals determines which fixed deposit tenure would be best for you. Being able to accurately estimate when you think you will need your funds back can help you avoid penalties due to early withdrawals.