Fixed deposits, like any investment, suit some investors and are wrong for others. They provide stability and guaranteed returns. They also lock up funds, however, so they are poor choices for investors who wish to maintain flexibility in their portfolios.
Depositors must leave their funds in these deposit accounts for a designated period. The deposits accumulate interest at a guaranteed rate. The rates are higher the longer the required length of deposit because longer term deposits allow the bank more flexibility in the investments that it makes. The bank borrows funds from depositors to make its investments. If it is guaranteed that the depositor will not withdraw funds for a certain period of time, it can participate in long-term lucrative investments without fearing unanticipated withdrawals that would force it into insolvency.
Many investors find these accounts to be attractive because of their stability. If you invest in a stock, it can go down in value so that you lose the initial money you invested. These deposits protect against that; you will always get back the principal plus your guaranteed interest rate. Also, fixed deposits are an asset that investors can borrow against. Finally, there are typically very low investment requirements for these deposits. Even a small initial deposit can begin accruing interest.
Fixed deposits do have drawbacks, however. Depositors cannot withdraw funds during the fixed period, so they have no access to that money in the event of an emergency. While it is possible to borrow against the fixed deposit account, they are then forced to pay interest to use funds that they could have simply withdrawn from another account. Unlike some other classes of investments, these deposits carry no tax protection, and interest is taxed as it accrues in the account. Inflation risk is also a concern, since high inflation will decrease the real returns on the deposit; in that environment, an investor would be better off buying an inflation-protected instrument.
Interest rate risk is a major concern for the holders of fixed deposits. This risk is a factor that can be a pro or a con depending on the investing climate at the time the deposit is made. Investment risk is the uncertainty of future interest rates; they could go up or down, depending on a variety of economic conditions. Fixed deposits lock in an interest rate that is determined by the current market conditions. If the interest rate is expected to fall, then a fixed deposit may be a good idea, but if interest rates rise then the fixed deposit may become unprofitable.