Term Deposits in 2020: A Complete Guide
What are term deposits and are they worth the fuss?
This is a question we hear a lot from our members, followers on social media, occasional trolls...
Everybody loves to hate on term deposits.
But asking whether term deposits are worthwhile is like asking if a hammer is worthwhile. It depends on what you're looking for.
A hammer is a terrible tool to hoe a garden or repair broken crockery. But if you're trying to put a nail in the wall, a hammer is a fantastic tool.
It's the same thing with term deposits: they're a great tool for the purpose they were designed for. What are they and what were they designed for? Let's take a look.
What is a term deposit and how does it work?
A term deposit is a cash investment you make with a financial institution that typically has a guaranteed return at a fixed interest rate over a set period of time (the term).
Although originally term deposits and Guaranteed Investment Certificates (GICs) were technically different, they’ve come to be interchangeable and mean the same thing, the main difference being what the financial institution you deal with calls them.
A term deposit can come in two forms: redeemable, which means you don’t have to wait until the complete end of the term to take out your money, and non-redeemable where your money is locked.
Depending on the term deposit, interest can be paid annually, at the end of the term or sometimes even monthly.
Types of term deposits
Term deposits come in all shapes and sizes. Here are the main features you'll want to look for to find the right term deposit.
Short-term vs. Long-term deposits
Depending on your goals and your financial plan, you can invest in a term deposit with terms ranging from one month to five or more years.
Short-term deposits will tend to have lower interest rates than longer-term ones.
Redeemable vs. Non-redeemable term deposits
The difference between redeemable and non-redeemable term deposits is pretty straight-forward. You cannot redeem non-redeemable terms deposits without incurring penalties whereas you can generally take out redeemable term deposits before the end of their term.
However, make sure you pay attention to the terms and conditions surrounding redeemable term deposits. There might be certain conditions. For instance:
- it might take 30 or more days before you have access to your funds
- you might only be able to redeem them on the anniversary date (e.g. after the first year of a three-year term)
- you might not get the full rate if you redeem early, but instead an early redemption rate
There are other possible conditions so make sure you read the fine print or ask your financial advisor before you deposit in a redeemable term deposit if you want access to your money.
Meanwhile, some term deposits are completely cashable, meaning that at any point during the term, you can take them out with no fees or penalties, along with whatever interest you've earned.
Again, because of their flexibility, redeemable term deposits will tend to have lower interest rates than non-redeemable ones.
Understanding whether your term deposit is redeemable, non-redeemable or fully cashable is essential based on your goals. If you are parking your rainy-day fund in term deposits, you'll want them to be liquid (readily available) so you can access your money in case of an emergency. If you're using them to build up your emergency fund or save for a purchase you know is 5 years away, there's less need for them to be accessible.
Special term deposits
There are other kinds of term deposits available. You could get a prime-linked term deposit, where the interest rate is not fixed but changes along with the prime rate. This gives investors a great opportunity to lock their money in while taking advantage of the interest rate environment. If prime rate goes up, so does the rate on your deposit.
Another popular form of term deposit is a market-linked or index-linked term deposit. These are tied to securities that historically have performed well. They tend to give investors a minimum guaranteed return, or at the very least protect their principal, with the potential for significantly greater returns (up to a maximum) based on the performance of the market.
You also can get a tiered interest term deposit. These tend to be fully redeemable products you can cash out at any time, but the interest is broken up over the course of the term. In the first six months, for example, you’ll earn a much lower interest rate than in the next six months. These term deposits are designed to give you the flexibility to access your money at any time while rewarding you for keeping it deposited as long as possible.
Are term deposits safe?
When people ask whether term deposits are safe investments, they generally want to know if they can count on their money being there at maturity.
Term deposits aren't affected by the market (with certain exceptions like index-linked terms). They're not like mutual funds where you have a diversified portfolio and you're banking on the combination of aggressive and conservative investments along with time in market to grow your money.
With a term deposit, you give your money to a financial institution. In the simplest terms, that financial institution then uses those deposits to provide loans. The interest the loans generate is what helps to pay interest on your term deposits.
Therefore, your principal and your rate of return are both guaranteed. Even if the interest rate on the term you deposited changes prior to maturity -- something that can happen at any time -- you will earn the original rate you got on the day you made your deposits. The exception to that is if you have a term deposit with a variable rate, in which case you're hoping the interest rates go up more than they go down over the course of the turn.
That's why term deposits are considered safe, conservative, short to medium-length investments and a great way to diversify your portfolio. Even during the 2008 financial crisis, term deposits were mostly unaffected.
Pros and cons of term deposits
The rule of investing is generally the safer the investment, the lower the return (also the shorter time in market, the lower the return). With the safety of a term deposit, you do sacrifice higher potential rates of return.
When you compare a term deposit to a high interest savings account, term deposits tend to have higher rates but the savings account boasts the flexibility of access to funds. With the term deposit, you're also locked into the rate you got when you made your deposit (with the exceptions already mentioned above), whereas the interest rate on your savings account can change at any time.
Something else to keep in mind is that term deposits are taxed at a higher marginal tax rate. Whenever possible, use available tax shelters, like your RRSP, TFSA, RRIF, RESP or RDSP. Not all term deposits are available with every registered plan, so make sure you check with your advisor.
Related reading: Complete Guide to TFSAs
Term deposit strategies
As we saw when comparing term deposits to savings accounts, one of the places savings accounts tend to have an edge is with liquidity (having easy access to the money in the account).
One of the ways experienced investors deal with that issue is by laddering their term deposits so instead of them maturing at the same time, they do so regularly.
Start by dividing your money into five equal parts and invest each in a term deposit from 1 to 5 years.
When your first term matures a year from now, reinvest those funds in a 5-year term. Repeat this process year-after-year so every year, you have a term deposit maturing.
Are term deposits worth it?
Term deposits often come under a lot scrutiny. Why would anyone invest in a product that's barely higher than the 2.00% inflation rate?
Certainly, if your long-term investment strategy is entirely dependent on term deposits then your gains, though guaranteed, will be hardly worth it at all.
Term deposits will generally give you a better rate of return than a typically savings account and much better than a chequing account or under your mattress. If you're parking money for an emergency fund or for a vacation in the next couple of years, a term deposit is a really great option.
The market boasts the promise of higher rates, but not without risk. Any investment you make, whether in stocks, bonds, mutual funds, ETFs... will ride both the ups and the downs of the market. The greater the potential return, the greater the risk. So the market may not be the best place to grow your money in the short term. With a term deposit, you rate is locked in and your returns are guaranteed. If you're saving for a down payment in the next five years, a term deposit is a great tool.
Advice you can bank on
This guide is designed to give you a comprehensive understanding of term deposits and some ideas of how you could incorporate them in your financial plan. The better you understand the various tools and products at your disposal and the way they work, the better decisions you’re able to make for your own future.
However you don’t have to do this alone. Our financial advisors have the expertise and experience to help you create a financial plan that’s based on your unique circumstances and that helps you reach your unique goals.
If you haven’t had a financial snapshot, take the first step towards understanding your complete financial picture and book one today.