What is a term deposit?
A term deposit is an investment specifically in cash, which is deposited with an Authorised Deposit-taking Institution (ADIs) for a fixed period of time, known as the term. These terms generally range from 1 to 5 years, with higher interest rates offered for longer terms. Term deposits are sometimes abbreviated as TD, and are known as a Certificate of Deposit or a CD.
There are two types of term deposits common in the Australian market. These are:
1. Standard Term Deposit:
These term deposits accrue a fixed rate of interest on the cash deposited during an agreed time period. At the end of the term, you have the option to withdraw all or part of the funds, automatically re-invest their funds or add extra funds to the investment. Should you wish to withdraw all or part of their funds prior to the end of the agreed term, you will need to make contact with your ADI. No notice period is required to be given to the ADI, however an “early access fee” will be incurred.
2. Advance Notice Term Deposit:
These term deposits are similar to standard term deposits, with a few differences. Unlike standard term deposits, should you wish to withdraw all or part of your funds, you will be required to give your ADI 31 days prior notice, in which time, the funds will be made available to you. In recognition of this advance notice, ADI’s generally offer slightly higher interest rates to standard term deposits.
Since term deposits provide the certainty of receiving a set fixed return, they are popular with investors looking for a low risk, low return financial product. The certainty is provided through the Australian Government Guarantee Scheme, which was introduced by the former federal government post the Global Financial Crisis. The scheme is designed to promote financial stability in Australia by guaranteeing all bank deposits, including term deposits, held in Australian ADIs.
Term deposits are frequently found in investors’ investment or superannuation portfolios, with more conservative portfolios having a greater weight towards term deposits.
The process for applying for a term deposit is similar to a normal everyday transaction account. Today, a majority of term deposits are able to be made online.
What are the benefits and limitations of term deposits?
There are a number of positive and negative elements to term deposits, and these include:
- You are guaranteed a specific return at the end of a term, irrespective of whether interest rates fall during the period
- Promotes financial discipline, given that your funds cannot be touched during the investment term without incurring an early termination fee
- Through the Australian Government Guarantee Scheme introduced by the federal government post the GFC, term deposits are guaranteed up to an amount of $250,000 per customer per institution
- While locking the interest rate provides you with certainty, it also exposes you to the possibility that future interest rates may move against you. For example, an investor enters into a 2 year term deposit when interest rates are 2%, and during the term, interest rates steadily rise to 4%. In this case, the investor misses out on earning interest at the higher rate
- Term deposits sometimes offer lower rates than online savings account
- There is little flexibility in terms of accessing your funds. Should an you wish to access your funds prior to term maturity, then a penalty will generally be charged
- Minimum deposit amounts generally apply, and can range from $1,000 to $10,000
- Some term deposits do not have online functionality and as such, it may require you to go to a branch to manage their account
- The calculation of interest is simple interest, so the benefits of compounding are not received
- Some term deposits automatically renew without informing their customers of the renewal date. As such, this takes away the ability for you to shop around for a better rate prior to maturity
- In order to open a term deposit, some institutions require you to also open a deposit account, which can have fee implications.
What to look for in a term deposit
You should look at both the pricing and features of a term deposit to determine the attractiveness of a particular term deposit.
There are two components to consider for the pricing of a term deposit. By far the main component is the interest rate offered by the product for any particular term. The other component is the maturity cost, which include any cost associated with retrieving or transferring your funds at maturity, such as the cost of a bank cheque for example.
The features consumers should look for in a term deposit include:
- Account options: How easy it is to open up a term deposit, whether a maturity reminder is provided and how it is delivered to the investor (eg SMS, email) and the number of days available to make amendments to the TD, such as adding further funds
- Bonus/discounts: Are there any bonuses or discounts on offer, such as a rollover bonus, free bank cheque or free direct credit should an investor wish to transfer their TD to another financial institution
- Early withdrawals: Does the ADI charge a prepayment interest penalty, what is the notice period required to be given for Advance Notice Term Deposits
- Interest options: What are the interest payment options available?
- Statement options: Is there the availability for the TD to be included in third party reporting and tax reporting
- Term options: Is there a requirement for a minimum investment amount, are rollover facilities automatic and can the TD be viewed on multiple platforms
How to choose the investment term
This may be an easy decision for you when you know you that you will require your funds term deposit funds at a certain time in the future. However, when you have no such restriction, then this decision becomes harder. On the one hand, you may be inclined to invest for a short period, say 3-12 months, in the hope that interest rates may increase in the future, while on the other hand, you may wish to invest for a much longer period of time to lock in the current term deposit rate, in the hope that interest rates fall in the future. Without the ability to predict the future, there is a chance you can get this wrong.
A method for hedging against the uncertainty is to “ladder” your term deposit. Laddering is a strategy where you place some of your funds in a long term deposit, and the remainder of your fund in a short term deposit that automatically renews at the current rate. This way, should interest rates rise, you don’t entirely miss out on the gains, while still providing the long term guarantee of a certain return.