What is a term deposit and how does it work?

A term deposit is an income-generating investment.

You take your money and lock it away for an agreed length of time. In return, you get a fixed interest return on that money.

For example, I recently had $10,000 available, so I put it into a term deposit at 6% for a year. That means the bank will pay me a 6% return over the next year. That’s $600.

So at the end of the year I get my $10k back, plus the $600 return.

Term deposits can be a good way to generate an income from your money if you don’t need that cash straight away. 

Even better, you can choose to get that money paid out every quarter if you want (and sometimes monthly). So in my case, I could get paid $150 a quarter from that investment.

The interest rate you get depends on what term you choose and how much you can put away, then the rate stays the same for the entire term.

This is great because you know exactly what the return on your money will be (once you can access the term deposit that is).

Compared to alternatives (e.g. managed funds and shares) term deposits are pretty safe. You know what your return will be upfront. Compare that to the share market where your return for the year is uncertain. This makes term deposits attractive to conservative, low-risk investors.

More from Opes:

• What are the current interest rates in NZ? (Article)
• Property vs shares vs term deposits vs funds (Article)
• Shares vs property vs term deposits - The 7 things you can't ignore (Podcast)

What are the pros and cons of term deposits?

There are pros and cons to term deposits as an investment option. Let’s go through them both.

The great thing about term deposits is there’s no guessing what your return will be.

You get a fixed interest rate set from the get-go. This means you know exactly how much your investment will make, and your return is paid in cash.

So this could help you sleep at night knowing your term deposit isn’t beholden to a changing market. And since they’re considered a low-risk investment, there’s little chance of losing money.

Term deposits are also easy to set up. The investor can do it all through their online bank account without having to speak to anyone; no forms or signatures.

At the same time, your returns from fixed interest are generally lower than if you invested in a managed fund or shares. That’s because lower-risk assets tend to also get lower returns.

But on top of this, your returns are taxed. For example, if I get a 6% return on a term deposit, this gets cut down to 4% once I pay tax (assuming a 33% tax rate).

Then, on top of that, the value of my investment is eroded through inflation.

So, if I get a 4% after-tax return and inflation is 2%, then my real after-tax return is just 2%.

That’s why term deposits are a good way to generate income but are not generally a good way to build your wealth.

That’s one reason retirees tend to like term deposits. They get a fixed income and they’re typically less concerned with growing their wealth but want to preserve the wealth they already have.

But, if you invest in a term deposit, your money is temporarily locked away. You can’t access it in a hurry. 

If you do need access to the money, like in an emergency, you may have to pay a penalty, and you will have to wait a certain number of days before it’s released to you. 

Some term deposits also charge fees for early withdrawals, which means you could end up with less than you expected if you need to access your money before the term ends.