Thursday, April 12, 2012

Term Deposits: How, What and Why

Me, Myself and My Term Deposits

My lesson on Term Deposits(TD) started when I was 13 years old. I remember my mum taking me to the bank and explaining that the interest rate that I was earning on my savings were very low at 2.25% and that the 6 month Term Deposits had higher interest rates at 4.75%.

This is why it's important to teach children when they're young. They're very impressionable and anything you teach them when they're young is seared into their memories because they're like little sponges that soak up every little piece of knowledge that you care to divulge to them. At that stage in school, we were being taught about simple interest and compound interest. So the concepts being taught weren't pie-in-the-sky concepts since my mum literally implemented those concepts for me.

After withdrawing the funds and depositing them into the TD, the bank lady tells me to come back in 6 months to roll over the funds into a new TD. It was pretty cool. The TD advices back then were printed on plush cream, linen cards with even a plastic slip over the top and it was placed in a plush cream envelope. Looking back, I think I may have been more excited over the stationary than the compounding interest Term Deposit!!

Nowadays, Term Deposit advices are pretty boring- they're printed on plain A4 paper and stuffed into generic envelopes. So yes, if you're trying to sell me something, make sure it's printed or advertised on luscious stationary and then I'll be hoarding your advertisment forever...

What Are Term Deposits?

For those who have never used a term deposit before, it's very simple. Most financial institutions offer them. Basically you take a lump sum such as $5,000 (or whatever amount you want to invest) and tell your bank that you want to place it into a term deposit and they will guide you through the options they have.

The basic features are:

a) Fixed interest (eg 3% or 5%)
b) Fixed duration (eg: 1 month, 3 months, 6 months or even 60 months etc)
c) Interest paid is set for the duration of the TD (eg: paid every 4 weeks, or 1 month, or 3 months or at maturity etc)
d) Maturity- when the TD expires and it roll overs into a new one or you can close the TD and deposit the funds back into your account
e) Roll over- when your TD matures, you can close it down or 'roll over' into a brand new TD with new set of maturity term and interest rate

What are the Drawbacks?

If you need your funds in an emergency and close the TD before maturity (the end date) then the financial institution typically penalises you such as halving the interest rate payable or dropping the interest return to something pitiful such as 1%.

Term deposits are also inherently structured to advantage the banks because of people's complacency. People typically open up high interest TD and then are too lazy to roll them into a new high interest term at maturity. Most people like to set and forget, so when the TD matures, it's automatically rolled over into a a new TD with the same maturity duration but pays very poor interest.

What are the Benefits?

* Usually higher interest rate than a transactional account (although with the proliferation of full transaction online saving accounts with high interest, this is no longer that applicable)

* You can lock in a higher interest rate in a decreasing rate environment (ie the Central Bank (RBA in Aust) keeps dropping interest rates). This girl I used to work with, her Grandma had locked in a 10 year term deposit for her and she was earning over 9% on her funds while we were all earning around 5% on ours. How awesome is that?

* Locks your funds away from easy access- good for those with butter fingers who can't resist the temptation. The idea of penalised interest may help create some resistance from temptation.

I rarely use TD nowadays but I used one recently because my bank had a special branch offer: 6.15% interest compounded every 4 weeks which was the best thing out there since the nearest competitors were offering 6.01%. It was so sad when that TD matured and I rolled it into my 5.41% 'high' interest savings account ;_; because there were no more fabulous TD specials on offer.

Best Uses of Your Funds

* If you have non-deductible consumer debts such as credit card debt or personal loans - you would be better off paying those first instead of bulking up your savings beyond the 'emergency fund' reqirements

* If you have a mortgage loan costing 7% versus a TD paying 7%, you're better off using those excess funds to pay your mortgage or use the funds to offset your mortgage loans (Offset accounts and paying any non-deductible mortgages are preferable for taxable reasons I won't go into details about in this post)

* If you have none of the above two, then Term Deposits and high interest savings account would be the next best use of your funds if you want nil risk

* If you want the potentially higher returns and higher risks- buy investment properties and invest into the stockmarket

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