How Inflation Affects Fixed Deposits: Simple Ways to Invest Smart
Key Takeaways:
Traditionally, Indians have preferred to park their excess funds in Fixed Deposits (FDs) for the security of their principal amount over potential returns. However, in any economy, inflation is inevitable, and India is no exception.
As of December 2024, the consumer inflation rate in India stood at 5.22%. This erodes the effective returns you earn by investing in FDs. Read more to learn about the impact of inflation on fixed deposits and strategies to combat it.
Understanding Inflation’s Impact on FDs
Consider that you have opened an FD with a bank that offers an interest rate of 4% p.a. Since the inflation rate in India is 5.22%, your real returns on an FD would be negative. In other words, while you are making 4% p.a., you are also losing 5.22% due to an increase in the general level of prices of different commodities and services.
High inflation generally prompts RBI to take corrective measures to maintain economic stability by increasing interest rates. If you are already invested in an older, low-yielding FD, you may miss the high-interest offers available after the RBI pivots its monetary policy.
If you decide to withdraw funds before maturity to invest in a higher-yielding FD, you will receive reduced interest earnings.
Strategies to Combat Inflation
While fixed deposits provide security and guaranteed returns, they may not always outpace inflation. This can be a significant concern, especially for those who depend on FDs for a steady income, like retirees.
Here are a few inflation-hedging strategies to consider to safeguard your wealth:
Opt for FD Laddering
This strategy refers to spreading your principal amount across multiple fixed deposits, maturing at different timelines. You can promptly book a new FD at higher rates in case the rates increase. It provides an opportunity to earn increased returns by offering flexibility to adapt to changing interest rates.
Choose an FD with Higher Rates
To earn more returns than inflation, check the average rate of increasing consumer prices in the last 10 years. Now, ensure that you invest in an FD that provides at least 2 to 3% higher returns than the prevailing inflation rate of the last decade.
Reinvest the Interest
To earn higher returns, ensure that you are reinvesting the interest accrued through a cumulative FD. By reinvesting the interest, you can earn even more returns due to compounding benefits.
Invest in a Tax-Saving Fixed Deposit
Under Section 80C of the Income Tax, you can enjoy a tax relief on 5-year tax-saver FD investments of up to ₹1.5 lakh. Currently, the interest rate for such FDs is between 5.5% and 7.5%, which beats the current inflation rate of 5.22%.
If you also account for tax savings, they increase your overall returns by 1 to 2% more than the actual rate of interest. So, you can beat inflation in this way.
Balancing Safety and Growth
To beat inflation and generate growth through your investments, you can consider certain alternatives to fixed deposits. If you seek fixed returns through FD, another strategy is to diversify your portfolio while investing a part of your total savings in this instrument.
You can consider investing in the following for protection of your purchasing power:
Long-term Investments
Public Provident Fund (PPF), Sukanya Samriddhi Scheme (SSS), and tax-free bonds are some of the alternatives you can look for. These instruments offer both safety and tax advantages, which can help mitigate inflation’s impact on your savings.
Short-term Investments
In this case, you can consider investing in an Equity-linked Savings Scheme (ELSS), which is a type of mutual fund with a lock-in period of 3 years. It provides tax benefits and has the potential to offer higher returns than FDs. You can also invest in short-term debt funds to earn better returns.
Learn about more strategies you can use to increase your FD returns.
Frequently Asked Questions
1. Can fixed deposits beat inflation?
Yes, fixed deposit returns can beat inflation, but this is not always true. This is why you must always conduct an analysis of FD vs inflation rates before investing in an FD.
2. How do I calculate real returns on my FD?
Here is how you can calculate real returns on your FD investment:
3. Should I reinvest FD proceeds at maturity?
Reinvesting FD proceeds can be a good option if you're looking for steady, low-risk returns, especially for long-term goals. However, if interest rates are low, explore other investment options or consider FD laddering for better liquidity and returns. Always consider your financial goals and market conditions before reinvesting.
4. Are there better inflation-hedging options than FDs?
Yes, you can consider investing in the following to earn better returns:
5. What happens to FD rates if inflation rises significantly?
If inflation rises significantly, the RBI may consider increasing interest rates to maintain economic stability. This means you can earn more returns on FD when the RBI increases the repo rates.