With interest rates rising, should I consider investing in a term deposit? (It depends)
Term deposits have long been a popular savings strategy. And with interest rates on the rise, it’s not uncommon to wonder whether a term deposit is a good place to put your hard earned money. Like any financial product, there are pros and cons to term deposits, and it really comes down to your objectives, financial situation and needs—and, how much flexibility you want with your money.
How term deposits work
A term deposit requires you to set away a portion of money (the deposit) for a fixed period of time (the term) with a financial institution. During that period—which can range from one month to five years, depending on the term deposit chosen—you will be unable to access that money (unless you pay a release penalty).
There can often be minimum and maximum deposit amounts, which can vary depending on the financial institution. As an example, the minimum deposit amount required can vary from $1,000 to $5,000.
Regardless of what happens in the markets or with interest rates, you’ll earn a fixed rate of interest over the specified term. Meaning, you’ll have a clear picture of how much you stand to earn on the deposit right at the outset.
For some, this certainty can make it easier to budget for any goal-orientated savings, such as saving for a new car or home renovations—and, because the money is essentially ‘locked away’ during the term, the temptation to spend it is removed (if, for example, it was held in a savings account instead).
Compared to other investments (e.g. investing in shares, managed funds, etc.), term deposits can also be relatively simple to set up and get going. You will often find that there are no establishment or account-keeping fees, unless you wish to access your money prior to the specified term ending. And, because you’re earning interest at a fixed rate, there’s no need to monitor how your investment is performing over time. The only exception to this is that when the term deposit reaches maturity, you’ll need to make a decision as to whether you withdraw it or have it “rolled over” into a new term deposit (potentially at a different rate).
Term deposits are generally considered a ‘safe’ investment because they’re guaranteed by the Government. In the unlikely event that your financial institution fails, you’re protected for up to $250,000 under the Government’s financial claims scheme.
Things to bear in mind
While you’ll continue to earn at a fixed rate of interest even if interest rates fall, this also means you won’t reap the benefits if rates go up in line with the market. You can think of this as an opportunity cost—you’re trading potential future gains in the market for safety and stability over the duration of the term.
Separately, there is also inflationary risk. This is the idea that the purchasing power of your money may decline while it’s locked away in a term deposit, cutting into the potential gains you might make. The difference between your interest rate (per annum) and the annual inflation rate is known as your ‘real rate of return,’ and this can be an important figure to keep in mind before considering investing in a term deposit.
Another consideration is tax. As with savings accounts, interest on your term deposit is considered income by the ATO and will be taxed at your income tax rate. How and when you declare that income will vary based on the duration of the term and the rate at which you receive interest payments. For example, if you receive the interest at maturity and the term is longer than 12 months, you will only have to declare it as income for the financial year in which you receive the full payment.
Finally, you should only consider committing to a term deposit if, among other things, you’re certain you won’t need access to that money while it’s locked away. And, while it’s possible to withdraw early, you’ll usually have to give a month’s notice and pay a penalty fee.
Word of caution about term deposit rollovers
Often when the initial term comes to an end, term deposits can be automatically ‘rolled over’ into a new term, potentially at a lower interest rate than your initial term. And, if you wish to withdraw your money once this rollover term has started, you may have to pay a release penalty. So, if you do not wish for your term deposit to be rolled over, then consider setting yourself a reminder with plenty of advance notice on when the term of your term deposit is up.
Like any financial decision, there are things to weigh up before you decide to invest in a term deposit. If you would like to talk to us about anything in this article, please get in touch.
