Some FDs are offering up to 9.5 per cent returns. How you can invest

What if someone offers you guaranteed higher interest rates? You'd bite their arm, of course.

But because the world of investing has shown that if something is too good to be true, it probably isn't, some of the experienced investors have refused to be swept off by the hype. Some have even flooded our mailbox in recent weeks, asking if the high-interest fixed deposits (FDs) offered by small finance banks is a smart option.

But first, we should understand how small finance banks are offering up to 9.5 per cent interest rates to their investors.

Small finance banks and 9.5 per cent interest rates

These banks primarily offer loans to the high-risk category of small businesses, farmers and workers in the unorganised sector. Due to the high risk, these banks are compelled to raise money from the market at a higher rate. Since FDs are one way of raising funds, these banks offer - rather, have to offer - higher interest rates to their depositors.

Are they a good option?

The above section indicates that these banks' FD rates are genuine and guaranteed.

The table below shows the rates offered by different small finance banks (SFBs) as of August 30, 2023.

Risk

Since SFBs deal with high-risk categories, your FD's risk level will be higher, too. They are more vulnerable to toxic loans (where loans aren't returned) than commercial banks such as SBI, HDFC and its like.

In such worst-case scenarios, your FD will come under threat, as DICGC (an RBI division) only offers a safety net of Rs 5 lakh. Put simply, if an SFB declares bankruptcy, you'll get back only Rs 5 lakh of your deposit in 90 days. The Rs 5 lakh includes both the principal and interest amount.

Liquidity

FDs have a lock-in period. You'd be penalised if you needed the money before that period. As a result, you'd earn lower interest rates.

That's where debt funds - especially liquid or short-duration funds - come on top. Here, you can withdraw your money at any given point.

Repeat tax

The tax treatment of FDs and debt funds is broadly the same, albeit with a slight twist.

Your interest income is added to the annual income and then taxed as per your tax slab. In simple terms, if you earn Rs 1 lakh in interest from either FD or debt fund, that money is added to your annual income and then taxed according to your tax regime's rate.

However, the one major difference is that the FD interest income is taxed every year. For instance, if it's a five-year FD, the interest you earn will be taxed on five separate occasions.

That's not the case with debt funds, such as liquid or short-duration funds. You are taxed only once, when you withdraw your investment.

Rigid structure

While FDs' fixed interest rate provides predictability, it can also be a drawback in a rising rate regime. Let's assume interest rates rise significantly during your FD tenure, you may miss out on potentially higher returns at that point.

Meanwhile, liquid and short-duration funds capture higher interest rates during these times, providing higher yields to their investors.

What you should know

• Some small finance banks offer 8.5 to 9 per cent interest rates on their FDs. For senior citizens, it ranges between 9 and 9.5 per cent.
  
• The median interest rate of a three-year FD in SFBs is 7.98 per cent. It's 0.5 per cent higher for senior citizens.
  
• On the other hand, short-duration debt funds, on average, are likely to yield 7.14 per cent, while a middle-of-the-road liquid fund delivered 6.63 per cent returns.
  
• So, if you invested Rs 4 lakh in a small finance bank FD for three years, your post-tax returns would amount to Rs 4.72 lakh after three years. (For senior citizens, it's Rs 4.77 lakh).
  Similarly, if you invested the same amount in a short-duration debt fund, your post-tax returns would be Rs 4.64 lakh.
  It would be Rs 4.59 lakh for a liquid fund.

• Why did we choose Rs 4 lakh? Because, if you remember, DICGC insures deposits only up to Rs 5 lakh (including interest amount) if a small finance bank bites the dust.

What you can do

Option 1

• Since SFBs provide higher interest rates, you can invest around Rs 4 lakh in their FDs. That way, you ensure your money is preserved. Remember DICGC's Rs 5 lakh insurance?
  
• Even if you have more than a Rs 4 lakh corpus, you can spread the money in different SFBs.
  
• This works better for retirees, who generally earn half a per cent more. That said, tracking multiple FDs invites a fair degree of paperwork and legwork if you are not internet savvy.

Option 2

• When it comes to fixed-income options, the primary objective should ideally be capital preservation, not capital appreciation.
  
• Even if capital appreciation is your main concern, the very nature of SFB's loan business is laced with risk. So, you should ask if it's worth taking that risk for that extra 0.8 per cent (the difference in returns between three-year FDs and short-duration debt funds).
  
• Crucially, short-duration and liquid funds buy quality instruments and are relatively safer than an SFB's FDs.
  
• And if you are okay with taking risks, we'd suggest you put a certain portion of the money in equity. It applies to senior citizens, too. We have always advised retirees to put at least 33 per cent of their corpus in equity. In the long run, equity has a higher ceiling than an FD when generating returns.
  That way, the risk-reward payoff will be more substantial.

So, why take a risk with FD that has an upper ceiling when you have equity? Split your money between a high-quality liquid or short-duration debt fund and a well-diversified equity fund.

Also read: Basics of bank fixed deposit