Your Money: Deposit rate cut looms, but don’t break that FD just yet

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Published: April 14, 2015 12:11:35 AM

HAVING cut base rates, banks are hinting at a drop in deposit rates as well. However, before you pull out of fixed deposit (FD) investments...

HAVING cut base rates, banks are hinting at a drop in deposit rates as well. However, before you pull out of fixed deposit (FD) investments, it makes sense to look at the impact of a premature withdrawal.

Impact of deposit rates on returns

State Bank of India’s current rate for FDs of more than five years is 8.5%. Assuming the bank lowers the rate by 25 bps to 8.25%, an investment of R5 lakh in a five-year FD will deliver R7.43 lakh at the end of the tenure. On the other hand, the current rate of 8.5% would have given you R7.51 lakh. So, in effect, you lose R8,000.

Impact of tenure on returns

Customers who have booked an FD for shorter tenures (up to a year) will be hit harder because their deposits will mature earlier and get renewed at the new rate. Also, any new FD account will fall under the new rate, which would likely be lower.

Let us take two scenarios. In the first case, a customer has invested R5 lakh in an FD for a tenure of two years at 8.5%. At the end of the tenure, the customer gets R5.88 lakh, which he reinvests at a reduced rate of 8% for two years, getting a final value of R6.86 lakh. In the second case, the customer invests the same amount of R5 lakh for four years at 8.5%, getting a final value of R6.92 lakh.

In both cases, the initial investment was R5 lakh and the tenure four years. Yet, in the second case, the final sum at the end of four years is higher by R6,400. Therefore, opting for a longer-term FD makes sense when the rate of interest at the time of investment is high, or expected to come down.

Premature withdrawals

Prematurely closing an FD account hurts you in two ways. One, the interest rate at which you opened the FD is no more applicable because you had opted for a longer term. Two, there may be a premature withdrawal penalty. Suppose SBI gives 7.5% return on deposits for up to a year and 8.5% for deposits of three years. You open a three-year FD account and deposit R5 lakh. However, you break the deposit after a year.

In this case, the bank will not pay the original 8.5% interest. It will, instead, pay the rate of a one-year FD, i.e., 7.5%. Moreover, the bank may impose a penalty of 0.5-1% on the premature withdrawal. So, the effective rate of interest drops to 7%. If you prematurely withdraw the FD after a year, the final value of investment would be R5.35 lakh. Had you allowed the FD to continue, the value at the end of one year would be R5.42 lakh — a difference of R7,500.

Should you stay put or withdraw?

SBI and HDFC Bank have slashed their base rates by 15 bps from 10% to 9.85%, Axis Bank from 10.15% to 9.95% and ICICI Bank from 10% to 9.75%. Usually, deposit rates follow the trajectory of the base rate. However, leading player SBI has not yet changed its deposit rate, except for the tenure of one year to 455 days (8.5% to 8.25%). Most other banks are still in the process of finalising their new deposit rates.

Long-term investors whose FDs are not maturing any time soon should stay put. Short-term investors should await the outcome of a few more policy meets and resultant bank responses before deciding whether to pull back their investments

Wait it out

* State Bank of India hasn’t changed its deposit rate yet, except for one-year tenure to 455 days (8.5% to 8.25%). Most other banks are still in the process of finalising their new rates
* Long-term investors whose FDs are not maturing any time soon should stay put. Short-term investors should await the outcome of a few more policy meets and resultant bank responses before deciding whether to exit their investments
* Prematurely closing an FD account attracts penalty. Plus, the interest rate at which you opened the FD is no longer applicable

The writer is CEO, BankBazaar.com

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