You must be very satisfied by investing in a bank fixed deposit (FD), thinking that the capital invested bears no risk and you would get a handsome return on maturity.
You must be very satisfied by investing in a bank fixed deposit (FD), thinking that the capital invested bears no risk and you would get a handsome return on maturity. However, to determine actual gains on maturity, you should check if the maturity amount after tax has beaten the rising price level or not.
If the after-tax rate of return is above the rate of inflation during the investment period, there will be real gain, otherwise, the money invested would lose its purchasing power at maturity.
For example, if the rate of inflation during a 5-year investment period is 5 per cent, to keep the purchasing power intact of Rs 1 lakh after 5 years, the after-tax maturity value must be Rs 1,27,628 and your bank FD should generate at least this amount on maturity after tax so that you don’t end up poorer by investing in the FD.
In the last year, the Reserve Bank of India (RBI) had announced a series of cuts in key policy rates, resulting in reduction in both lending and deposit rates.
Currently, the RBI policy rates are – Policy Repo Rate 5.15 per cent, Reverse Repo Rate 4.90 per cent, Marginal Standing Facility Rate 5.40 per cent and Bank Rate 5.40 per cent.
As lending and deposit rates are linked to Repo rate, the 5-year Repo-linked bank FD rates vary around 6-7 per cent, and some banks are still cutting the rates to pass on the benefits of RBI rate cuts to customers.
However, lately, there has been a steep rise in the rate of inflation, mainly due to sharp rise in food prices and for January 2020, the Consumer Price Index (CPI inflation) was as high as 7.59 per cent.
“The sharp spike in food inflation has led India’s Jan CPI to breach a six-year high of 7.59 per cent compared to 7.35 per cent seen in December. It is the consecutive second month, that CPI has breached the upper band of RBI’s inflation target,” said Rahul Gupta, Head of Research- Currency, Emkay Global Financial Services.
“In contrast to market consensus of 7.4 per cent and our exp of 6.9 per cent, Jan’20 headline inflation moved higher to 7.6 per cent from 7.4 per cent earlier,” said Nikhil Gupta, Chief Economist at Motilal Oswal Financial Services, adding, “CPI details are more worrisome. Core CPI rose to 4.2 per cent and CPI ex vegetables rose to 40-month high of 5 per cent.”
“CPI inflation has surged further mainly due to spike in food prices and telecom tariff hike. This is the second consecutive month of inflation above RBI’s upper target of 6 per cent. Sustained high food inflation could result in inflationary expectations rebounding and RBI would be wary of that,” said Rajani Sinha, Chief Economist & Head Research at Knight Frank India.
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So, the rate of inflation has become more than the rate of interest offered by banks on FDs, even without taking the effects of income tax into consideration.
To keep the purchasing power intact, an investor, who needn’t pay any tax, should earn interest at the rate of prevailing rate of inflation, i.e. 7.6 per cent, assuming that the rate of inflation would remain static during the investment period.
So, to keep the purchasing power intact, Rs 1 lakh should grow at an after-tax rate of 7.6 per cent become Rs 1,44,232 in 5 years. To have a positive gain on maturity, the principal invested should grow even at a higher rate.
On the other hand, a person in 10 per cent tax bracket should get 8.44 per cent interest on FD to ensure that the purchasing power of the money invested remains intact after paying tax.
Similarly, investors in 20 per cent and 30 per cent tax brackets should get interest rates of 9.5 per cent and 10.9 per cent respectively, to beat inflation.
So, at the current rate of interest, you would end up poorer on maturity by investing in bank FDs if such a high rate of inflation continues against such a low FD rates offered by the banks.