Right now at most banks across New Zealand, you can lock in term deposits for 5 years at over 5% p.a.
Are these a good investment?
First of all – yes, 5% is generally a decent rate of return for a risk-free investment.
For example, let’s say your net worth was $5 million.
You could put that entire $5 million into term deposits at 5%, and you would collect $250,000 per year.
That’s a quarter million for doing literally nothing and taking on zero risk.
Pretty nice, huh?
But there are also limitations to term deposits.
Firstly – they expire.
If you lock in a 5-year term deposit today, it’ll expire in 2028.
For all you know, interest rates in 2028 could be down to 1%.
Now you have to renew your term deposits at a measly 1% interest rate, or you have to find somewhere else to put your money, and while your money was sitting in term deposits, stocks and real estate might have had a bull market and rocketed up.
So while a high-interest term deposit might give you peace of mind, it still may not be the best choice long-term.
To find out for sure, let’s crunch some numbers.
To make things easy, let’s imagine we have the option to lock in a term deposit at 5% forever.
Assuming we’re on a 33% tax rate, that means we’ll end up with around 3.35% p.a. in the pocket.
If we invest $50,000 in cash, after 30 years we will have:
$136k – not bad.
Now let’s compare that to the index.
We know the NZX50 has returned around 10% per year over the past 30 years, and that excludes dividends. So it’s actually closer to around 12.5%.
Investing in the index usually costs about 0.2% in fees.
Taxes are nil because our dividends have imputation credits, and capital gains in NZ are not taxed.
Let’s call it 12%.
If we invest our $50,000 in the NZX 50 index for 30 years, we’ll end up with:
Almost $1.8 million.
Big difference from $136k.
Why is the difference so big?
The reason is three-fold:
- When you invest in stocks, you’re investing in businesses, and capital in a business will grow while starting capital in a term deposit will not.
- Stocks are more tax efficient than term deposits.
- Stocks benefit from economic growth and money printing, term deposits do not.
These all contribute to higher annual returns for stocks, which obviously lead to more growth.
Based on these numbers, I would not consider high-interest term deposits to be worth it based on returns alone.
The opportunity cost is simply too high.
Of course, an index fund contains more risk than a term deposit, but the difference in upside is asymmetrically bigger.
If you invest in a 5% term deposit, the most you can ever make is 5%. If you invest in the index, the upside is technically unlimited.
When Are Term Deposits A Good Investment?
Even though term deposits might not offer you the best long term returns, they do offer you the best long term safety and stability, and therefore can be good in certain situations.
For example, let’s say you’ve made/saved a healthy amount of money and are now worth $10 million. You just want to retire and not worry about money anymore.
Putting half your net worth into cash assets like savings accounts, bonds and term deposits can be a good option for you.
Even at 2% per year, a $5 million deposit will bring in $100k passive income per year. You will never need to worry about money ever again. And, the other half your net worth will still be sitting in assets, working. If you’re someone that likes certainty and hates dealing with money issues and decisions, an option like this might appeal to you.
Another good reason can be you are near retirement age and don’t want to risk being caught on the bad end of market volatility. As we know, markets are reasonably predictable over the very long-term, but very unpredictable in the short term. Imagine if you had just turned 65, had all your money in stocks, and then just before you wanted to cash out your retirement fund, Covid hit. The market dumps 50% in a matter of weeks, and now you’re sincerely crapping yourself.
Therefore, investors on a much shorter time frame might want to think about locking in 5 year term deposits at the current juicy 5%, for peace of mind while still getting a respectable return.
A final reason the current high-interest term deposits might appeal to you is if you expect you will need the cash in the near future. Let’s say you’re about to get married and you’re not sure whether you’re going to need your cash to buy a house/pay for the wedding or honeymoon/have a kid soon. Putting it into the market could be risky because, like we said, markets are volatile and unpredictable in the short term. Putting your cash into a term deposit will be safer, as you know you’re not going to lose money, and you know the cash will be there whenever you need it. Remember – even if you lock in a term deposit for 5 years, you usually can still access it earlier than that – you will just be subject to a term deposit break fee, which is usually not prohibitive.
Overall, term deposits are a nice options to have and can be tempting, but if your time horizon is intermediate to long term, they are inferior to stocks when based purely on returns. Use them to park your money in special situations, but for long term compounding, stocks remain king.
I personally have not taken on any term deposits at the current rates and do not plan to. A good alternative, however, are the Notice Saver accounts available at most banks, which offer around 4.5%, and only require you to lock your money for 90 days! It’s a good place to keep cash parked if you’re keeping it on the sidelines.