What is a term deposit?

A term deposit is a type of savings account where you lock your money away for a set period and earn a guaranteed fixed interest rate. Let's weigh up the pros and cons.

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A term deposit is a type of savings account where you invest a minimum amount of money for a set period (the 'term') in exchange for a fixed interest rate. 

The term can be anywhere from a few months to a few years, and the interest rate will be higher than that of typical savings accounts. Banks and other authorised deposit-taking institutions (ADIs) traditionally offer term deposit products.

A crucial aspect is that term deposits require you to lock your money away for the duration of the term. If you need to withdraw your money earlier, you will usually have to give 31 days (!) notice and likely be charged a penalty fee. You may even have to forfeit a portion (sometimes all) of the interest you'd earned up to the withdrawal date.

This distinguishes term deposits from typical savings accounts, where you always have easy access to your money (but earn a pittance, if anything, in interest).

How term deposits work

Let's explain how term deposits work with a quick example.

Your bank may advertise a term deposit product with a minimum investment of $5,000, paying a rate of 5% per annum for 12 months. This means you must make an initial deposit of at least $5,000 and leave it locked in the account for an entire year. If you do so, at the end of the term, you will be paid 5% of your opening balance ($250 for the minimum $5,000 investment).

Term deposits usually don't offer compound interest. Instead, your interest is paid in one lump sum at the end of the term or annually if the term is longer than one year.

On the plus side, term deposits also usually don't charge any establishment or account fees. Other than an early termination fee if you decide to withdraw your money before the term ends.

Term deposit vs other savings accounts: What's the difference?

The main difference between term deposits and other savings accounts is how readily you can access your money. 

With a typical savings account, you can make withdrawals and use your money for everyday purchases. In a term deposit, it's locked away for the duration of the term.

This means that you should carefully consider your budget and any significant upcoming expenses before you open a term deposit. 

If you open a 12-month term deposit, and then three months in, you suddenly remember you need an extra $1,000 for your annual car registration or to cover a vet bill for your cat, you can't just pull that money out of your term deposit. 

You will likely forfeit a portion (potentially all!) of the interest you've already earned. And you'll probably also get whacked with an early termination fee which could leave you financially worse off than if you hadn't opened the term deposit at all.

What's in it for the bank?

When you deposit money with a bank, it takes the funds and uses them to finance loans to its other customers. The bank writes its loans at a higher interest rate than it pays its depositors, pocketing the margin. It's how it makes the majority of its money.

However, there is an apparent timing mismatch here. Many loans – particularly mortgages – can last decades, whereas you are within your right to withdraw all your money tomorrow if you want to. This creates a risk for the bank – at any moment, its funding could disappear.

We all remember that scene from It's a Wonderful Life when there is a run on the bank, and poor old George Bailey has to convince the anxious townsfolk that he can't return all their money to them because it's tied up in other people's loans. Tragically, he has to use his savings as a backstop to cover the town's withdrawals.

No bank executive wants to be in George Bailey's position. So, they mitigate the risks of this timing mismatch by encouraging people to lock up their deposits for longer. This gives the bank access to a much more stable funding source, reducing its risk and improving its profitability.

To incentivise customers to take out term deposits, the rates offered on these products will be higher than typical everyday savings accounts. This can mean earning a very attractive return on your money (provided you can afford to lock it up for a year or two).

Term deposits vs ASX shares

Term deposits can provide many benefits over ASX shares – although whether you see them as positives might depend on what you are personally trying to get out of your investment. They also have some obvious drawbacks versus ASX shares.

We've summarised some of the key pros and cons below.

The pros…

Lower risk: Term deposits are protected by the Australian Government's Financial Claims Scheme. The scheme guarantees to repay all deposits held with Australian banks (up to a maximum of $250,000) in the unlikely event your bank or ADI collapses.

But there's no nice pillowy claims scheme to catch you if you buy ASX shares just before their prices collapse. If that happens, you're the one who's on the hook for it.

Certain return: Precisely because they are low-risk investments, term deposits give investors certainty. They know how much money they will have in their pocket by the end of the term. This can be particularly desirable if you have specific savings goals – like a new car or an overseas holiday. 

ASX shares, on the other hand, are much more unpredictable. You can potentially earn much higher returns trading ASX shares than investing in a term deposit. However, the value of your shares could also decline. This more comprehensive range of potential outcomes makes ASX shares riskier to own.

No fees: Banks are so greedy for term deposits that they usually don't charge establishment or account fees. This compares with buying ASX shares, where brokerage fees are charged for every trade.

And the cons…

Lower returning: As we've already touched on, term deposits are a less risky option than ASX shares. But, with a little luck and good judgement, you can usually still earn a higher return (over time) trading ASX shares than you can from holding a term deposit.

The long-run average return of the ASX All Ordinaries Index (ASX: XAO) is about 10% per year1. Currently, the highest-returning term deposits offer an annual return of about 5%. So, provided you're comfortable with the risks, share trading generally delivers a much better return.

High initial deposit: Most brokers allow you to start trading ASX shares with as little as $500. And some smaller digital trading platforms will let you start trading with even less than that. This makes investing in ASX shares within reach for just about everybody.

Term deposits, on the other hand, usually require a much higher initial deposit (think $5,000 and up). When you consider what the bank is trying to get out of a term deposit, this makes sense. The more money it can encourage its customers to lock away, the more stable its source of funding.

However, this can also mean term deposits aren't affordable for every investor.

Locked away

Less control: Probably the biggest drawback to term deposits is that your money is locked away for the term. If you need it earlier, you will have to pay an early withdrawal penalty (and give up the gains you've made).

This isn't to say that ASX shares don't carry similar risks. For example, a sudden unexpected expense pops up, meaning you need some extra cash in a hurry. If you had to sell your shares to cover the bill, and their current price is below what you paid to buy them, you will be forced to realise a loss.

On the flip side, if your shares have made significant gains and you'd like to take some profit, you can quite quickly dispose of your shares and have that money in your pocket within just a few days. This clearly isn't possible with a term deposit.

Can you earn more with a term deposit than ASX shares?

As we touched on earlier, Australian shares tend to (over time) deliver an average annual return well above what you could earn on a typical term deposit. This compensates investors for the added risk they take by investing in the stock market.

However, it doesn't mean you should always invest in shares rather than a term deposit. All asset classes (like shares, bonds, commodities and other financial assets) have a place in a well-balanced, diversified portfolio. By combining these different assets, you can adjust your risk exposures until they are at a level that you're comfortable with.

For example, you could combine an investment in a term deposit (which gives you certainty about how much money you will have at the end of the term) with the less certain ASX shares.

The shares provide additional potential upside from capital growth. The term deposit offsets some of your potential losses if the share market goes belly-up. So it essentially works as a hedge.

Also, as we mentioned earlier, term deposits can be good to use when you have specific savings goals in mind. You can lock your money away in a term deposit, so you won't be tempted to spend it on something else. And you already know exactly how much money you'll have when it matures at the end of the term.

How do interest rates affect term deposits?

Interest rates and inflation can significantly impact term deposits – particularly those with longer terms. If the central bank is in a tightening cycle – meaning it is regularly raising the cash rate – this can quickly make the interest rate you receive on your term deposit unattractive.

For example, you might open a 24-month term deposit paying 4% interest per annum when the official cash rate is 2%. At that time, earning 4% interest seems pretty good, considering it's double the cash rate. 

However, if the RBA starts rapidly hiking the cash rate (like it did in 2022 and 2023) and rates reach 4.5% by the end of the first year, suddenly, your term deposit isn't such a great deal anymore. The term deposit now pays less than the official cash rate, and your money is still stuck there for another 12 months.

Of course, the opposite is also true. If you open a term deposit when rates are high, and the RBA starts reducing the cash rate, your term deposit becomes more valuable. Banks will unlikely offer term deposits paying 4% when the cash rate is close to 0%.

What about inflation?

Inflation can also impact the actual value of your term deposit. When inflation is high, prices for common goods and services increase. Essentially, your money doesn't buy as much stuff as it used to. Suppose you have your money stuck in a term deposit for two years when inflation is running hot. In that case, it may mean your money's 'real' value declines (if the interest rate on your deposit is lower than the inflation rate).

Both risks – interest rates and inflation – are due to the fact that you have to lock your money away for a long period when you open a term deposit. These risks get larger the longer the term because the economic outlook is more uncertain the further you look into the future.

Should I invest in term deposits, shares, or both?

The choice between shares, term deposits, and other asset classes really comes down to your risk tolerance and investing objectives.

If you can stomach daily swings in the value of your portfolio (with the chance to bag some great, long-term gains), then the stock market is for you.

If, on the other hand, you are mostly concerned with preserving the value of your portfolio and are content to see it grow only gradually over time, then you might be better suited to a term deposit.

Chances are, you probably sit somewhere in between those two extremes. This means that you might want to take on a bit of the share market risk, but don't want to lose all your money if things go pear-shaped. In this case, you could combine different assets (including term deposits) within the one portfolio until you get to a point where it meets your personal objectives.

Of course, if you're struggling to work out how to build a portfolio that best meets your financial needs, it's always best to speak to a finance professional.

Frequently Asked Questions

A term deposit is a type of savings account where you commit to locking away your money with a bank for a certain period (the "term"). Term deposits pay more interest than typical savings accounts, but you generally forfeit your earnings and pay a penalty if you withdraw your money early. On the other hand, if you can afford to leave your money untouched for the whole term, you are rewarded with a guaranteed payout.

It depends on your investing objectives. Term deposits are low-risk but aren't as high returning as other asset classes, like ASX shares. However, they can still be helpful for investors mainly concerned with preserving the value of their wealth or those with specific financial goals.

The major disadvantage of a term deposit is that it requires you to lock your money away for the duration of the term. If an unexpected expense pops up and you need to access your money quickly, you must pay high fees to get it back. There are a few other disadvantages, too. Term deposits usually require a chunky minimum deposit, which means they aren't affordable for everyone. They are also lower returning than other asset classes – but may still suit some investors with a low-risk appetite.

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This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

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The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.