A term deposit is an account where you can deposit cash and generally receive a higher rate of interest than a savings account. As such it can be an ideal investment for someone who requires regular and guaranteed income. However, don’t underestimate their usefulness for any portfolio.
What is a Term Deposit?
It is an investment where you 'deposit' your money with a financial institution for a fixed term. The interest rate is fixed for the nominated term of the deposit and you are guaranteed (by the institution) to get your interest payments as specified, and capital repaid at the end of the term. You will always know exactly how much your investment is worth. Always remember that the guarantee is only as good as the institution that provides it.
If you choose to end your term deposit early, there may be penalties incurred for early withdrawal.
Term Deposits can have a maturity ranging anywhere from a month to a few years and they are extremely safe investments which are attractive to conservative or low risk investors. However, they can be used in a variety of circumstances and should not be overlooked as part of a strategic financial strategy.
Let’s explore a couple of scenarios to see how term deposits can be used.
Case Study 1 – Malcolm and Jane
Malcolm and Jane are newlyweds and are living in a small flat which they rent. They both earn reasonable salaries and are able to put away $500 each month in savings. They are keen to save for a deposit on a house and they were lucky enough to be given a $1,000 in cash as wedding gifts. Between them they also have $11,000 saved. A friend has recommended investing in the share market for some quick returns but Malcolm is fairly conservative and has been learning about a variety of investments and he believes that because he and Jane will need the money in about 3 years to buy their first home that the share market is not the right place for their savings at this time. He decides to put the money in a series of term deposits to help grow their savings over the next three years.
Here’s what he does. He has researched the rates and at the moment the 6 month term deposit rate gives him the best balance of flexibility and a reasonable interest rate of 6.3%. He decides to divide the $12,000 up into 6 equal amounts and invests the first term deposit of $2,000 plus a months savings of $500 in a 6 month term deposit. Every month for the next five months, he invests $2,000 plus a months worth of savings. At the end of 6 months he has 6 term deposits of $2,500.
Each month after that, all he has to do is set up a new 6 month term deposit made up of the amount from the matured term depost and the interest paid plus his savings for the month.
In the 2nd year of this strategy Malcolm and Jane both get a $30 a week pay rise which they decide to add to their savings meaning that they can now save $740 a month. They are lucky to get another pay rise in the 3rd year which they also add to their savings meaning a total of $980 is being saved each month.
At the end of the 3 years they have managed to save nearly $42,500 which together with the first home owners grant, they use as a deposit on their first home.
If you are interested in seeing the calculations behind this strategy or want to use the spreadsheet to manage your own term deposit strategy, download the Term Deposit Strategy Template.
Case Study 2 – Joan and Bruce
Joan and Bruce have retired and their SMSF is structured conservatively. They are comfortable knowing that they have 2 year's worth of pension payments in their SMSF’s cash account but Joan isn’t convinced that having this money sit there is the most effective use of their funds and it isn’t as if they need to access it every week. Their pension payments are mostly covered by the dividends they receive from the share portfolio of high dividend yielding stocks that make up the remainder of their SMSF. The franking credits that the SMSF gets back also contribute to paying their pension payments but of course they only come into the bank account once a year.
Joan decides to divide the $120,000 cash the Super fund has set aside into 12 equal amounts of $10,000 each. Each month for the next 12 months she progressively invests $10,000 in a series of 12 month term deposits. In 12 months time the term deposits will mature on a monthly basis so she is comfortable that should an emergency occur and they need to access the cash there will only a short wait until extra funds are available. Instead of earning 2.4% in the cash management account the SMSF’s cash funds are now working harder earning 6.7% pa. The interest that each term deposit earns will go back into the day to day account as each term deposit matures to help smooth out the cash flow and only the principal will be reinvested. For very little effort each month Joan is happier that she is getting the most out of her SMSF’s cash amounts.
If you are interested in comparing different Term Deposits, visit the Canstar Cannex site and look for the Comparison Rate Tables. The link will take you to the comparison rates for $1,000 but have a browse to search for rates on higher amounts.