AMFIE ACADEMY - Investing in a term deposit
AMFIE ACADEMY Investing in a term deposit
Given the uncertainties regarding the markets and the low interest rates investors have experienced for several years, many people are tempted to place funds in term deposits (also referred to as ‘fixed-term deposits’). But what exactly are term deposits and what risks do they carry?
Term deposits are money market investments in which funds are held until maturity in exchange for a fixed interest rate for the period of the investment. Rates will vary depending on the currency and term of the deposit. Once the investment reaches maturity, the investor receives his or her initial capital and the interest generated over the period. When term deposits are withdrawn before maturity, the investor usually faces a penalty or loses all of the interest earned.
What are the advantages of investing in a term deposit?
Term deposits are a relatively secure way to invest funds over the short-term. The money invested remains fairly accessible, giving you the flexibility to invest elsewhere, should the opportunity arise.
They also offer a guaranteed rate of interest for the entire term of the investment. If market interest rates decline, you will still benefit from the fixed rate for the entire term of the deposit. In addition, they generally pay higher rates than savings accounts and allow for low minimum deposit amounts.
What are the main disadvantages and risks associated with investing in term deposits?
Although term deposits are one of the most secure investments, they do carry different types of risks. While interest rates on term deposits are higher than those offered with savings accounts, they are often lower than most fixed-rate investments. Even more problematic, they are generally lower than the inflation rate (a measure of how much prices rise in a given year) and therefore do not allow you to keep up with inflation.
In addition, they carry interest rate risk. The interest rate you receive on your term deposit stays the same, despite market rate fluctuations. If interest rates rise, you will not be able to invest elsewhere without losing the interest accumulated or facing penalties.
Term deposits also carry credit risk, which is linked to the financial stability of your financial firm or bank. Finally, if your deposit is denominated in a foreign currency, you will face currency risk as the value of your invested capital will be linked to fluctuations in the value of the foreign currency.