Term deposits are an ever-popular product, but does being popular make them a worthwhile investment in the present financial climate?
Why do people invest in term deposits?
One of the main reasons people invest in term deposits over other investment assets is for safety. Since the Banking Act 1945, deposits with authorised deposit-taking institutions (ADIs) have benefited from high levels of regulatory protection that minimise the risk of losses. This protection was greatly strengthened with the introduction of the government deposit guarantee in 2008, which made term deposits virtually risk-free.
The popularity of term deposits skyrocketed following the start of the global financial crisis in mid-2007 when Australian investors fled equities for the safety of term deposits in their droves, as you can see in the graph below.
Another reason many investors favour term deposits is because of their simplicity: You deposit a lump sum of money with an ADI for a fixed interest rate over a set period of time (known as the term). At the end of the term (maturity), the deposit is paid back to you along with the interest it earned.
Of course, there’s more to them than that, but that’s the general idea.
Term deposits are essentially a guarantee that you’ll at least earn something on your investment. This may be a real positive for the more risk-averse investors, particularly seniors and retirees who often prefer a more conservative asset allocation in order to protect their hard-earned retirement dollars. They can also benefit those saving for short-medium term purposes, like Christmas presents for the family or an upcoming holiday.
However, after tax and inflation are taken into account, a term deposit can actually make you a real loss.
Why do banks offer them?
Deposits make up a significant portion of funding for banks, which they use for their various operations. If you’ve ever wondered where your home loan lender got the money for your house from, there’s a good chance some of it came from term deposits.
According to APRA’s monthly banking statistics for November 2018 (the latest data available), Australian Banks hold a total of $919 billion in household deposits – that’s nearly half of the more than $2 trillion held in total deposits across the industry.
The current term deposit rates
As at January 2019, the average term deposit interest rate across all terms offered on the market for a $10,000 deposit is around 2.30% p.a, which is just 40 basis points above the inflation rate (1.90%). The graph below shows what the average rate is for each available term – these rates are generally higher for longer terms.
So the highest average rate is 2.71% p.a. for a five-year term while the highest across all providers for this term at the time of writing (January 2019) is 3.40% p.a. But rates can change up or down, which is the risk long-term deposits pose for investors if interest rates were to rise. Because the majority of term deposits are fixed, you could miss out on higher interest rates. Of course, rates can also go down.
Will term deposit rates rise soon?
This is a matter of speculation, as a major influencer of term deposit interest rates is the official cash rate. The RBA generally increases rates when the economy is growing too fast (to prevent the inflation rate from soaring over 3.00%) and lowers rates when the economy is struggling to grow.
Theories on whether future rate changes will be rises or falls are different depending on who you ask. The consensus of most economists is that there won’t be a rate change until at least mid-to-late 2019, while RBA Governor Phillip Lowe said in late 2018 that interest rates will rise ‘at some point’, which means approximately nothing. While the next change is expected to be a rise, a number of prominent economists think it will be a cut.
Which investments provide the highest returns?
Each investment class has a different level of risk, which also correlates to their potential returns. Products with low returns tend to be low-risk, meaning there’s less chance you’ll lose your money. There are four key assets classes – cash, property, fixed income and equities (shares) – each of which have different risk profiles:
(Term deposits, savings accounts, management trusts etc.)
|Low||Low||Interest may not outpace inflation long-term, are more suitable for short-term investors with low-risk tolerance.|
(Government bonds, corporate bonds etc.)
|Low/moderate||Moderate||More likely to outpace inflation but still a more stable asset to own.|
(Domestic, commercial and international)
|Moderate/high||Moderate/high||Higher risk and higher barriers to entry (mainly cost!) but can provide tax advantages and income + capital growth|
(Individual shares, ETFs, managed funds etc.)
|High||High||The most volatile asset class, but historically gives positive returns if you have the patience for long-term investing|
As a cash investment, term deposits are considered to be one of the lowest-risk investments, which means you’ll have to put up with lower returns. The next asset class up from cash are fixed interest assets, such as government bonds. To summarise bonds in a single sentence: you lend money to governments or corporations in exchange for a fixed rate of interest at regular intervals, with the principal investment returned to you at the end of the term.
Equities and property give higher returns but are usually much riskier to invest in. House prices in major hubs like Sydney and Melbourne have been prone to significant movements up and down, while there’s often much uncertainty in share markets. The graph below demonstrates the average long-term annual returns of such assets compared to the average rate of inflation:
Not all investors are equal, and some will definitely prefer a more passive, low-risk term deposit over a share portfolio. Think about your risk profile before deciding what to invest in:
- What’s your time horizon? If you’re investing for the long-term then you may have time on your side to ride out any dips in the share market or property market.
- What are your investment goals? Consider whether you’re investing primarily to grow your capital or earn a stable income. Term deposits will provide you with a fixed interest income but low capital gains while shares can generate large capital gains but low income (dividends, franking credits etc).
- How much can you afford to lose? If you’re investing in high-risk assets, you generally shouldn’t invest anything you can’t afford to lose.
Diversifying your portfolio to include both low and high-risk assets can be a smart way to balance the good and bad days. With any investment, you should consider seeking professional advice to help you reach your financial goals.
Savings.com.au’s two cents
Choosing where to invest your money can be a tough decision at any point in time. Do you accept the risk and volatility of the sharemarket, or do you go for the safe and cuddly term deposit that guarantees a stable, albeit small, return?
Generally, your portfolio should have a mixture of both defensive assets (e.g. cash and bonds) and growth assets (e.g. shares and property), so that you can grow your net worth while having cash aside for emergencies. The ratio between these (e.g. 90% defensive:10% growth or 40% defensive:60% growth) will depend on your risk appetite.
Investing solely in term deposits is unlikely to represent a good long-term growth strategy for a number of reasons:
- Interest rates can go up while you’re locked into a fixed rate
- Your earnings can be stripped away by inflation and tax
- You may miss out on much larger returns on the share and property markets
However, your cash pile is likely to be better off in a term deposit than a transaction account (which pay barely any interest), and there is plenty of competition between the banks that offer them, leaving you spoilt for choice. So if you’re looking for a term deposit, choose one with a combination of high interest and flexible conditions, such as the ability to make partial withdrawals.