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Investing It!

Fixed Deposit - Watch out for that Penalty!

Fixed deposit interest rates Fixed Deposit Investors have a reason to cheer, with almost all banks increasing the fixed deposit interest rates across the board. If you are among those investors who have put in some money recently in a bank fixed deposit and are thinking that you should be reinvesting it at the higher rate, if you are about to withdraw your money prematurely to benefit from the better rates, then WAIT! This decision is not as straight forward as we would like to believe.

                
You may be wondering, how wrong one can go with a decision related to a fixed deposit! True there is no risk, but have we ever gone through the bank’s deposit policy? Unlike Insurance or Mutual fund investments no one urges us to read the deposit policy of the bank right! Before you press that “Liquidate Deposit” button, here is what you need to know?

              
1.    What is the premature withdrawal policy that your bank follows?

                
Most banks have a pre-term penalty clause attached to the pre mature liquidated deposit. This is to the tune of 1% on the interest rate applicable for the tenure till liquidation. This means that if you have booked the deposit in the month of August and you wish to benefit from the increased interest rates in December then the following will be the manner in which the penalty will be calculated.

              
Suppose you invested Rs 1 Lakh in a fixed deposit for 1 year at the rate of interest of 7% and the rates were revised at 7.75% in the month of December. If you are thinking of reinvesting that Rs 1 Lakh at 7.75% then the following is how it will shape up.
                   

Since you are withdrawing your deposit 3 months post booking, the bank will calculate the rate of interest applicable for 3 months by 4.25% and deduct 1% as penalty. This means that 3.25% is the rate of interest that the bank will pay you on your Rs 1 Lakh. This means that you will receive Rs 812.5 as interest for the 3 month period.

                     
If you wish to know your banks deposit policy, they should have one mentioned on their website. If you are unable to find it, make sure you call the customer service number and ask. This is a vital piece of information that you need to know before making any decision regarding your FD.

               
2.    Does the increase in the interest rates compensate for the impact of the pre-term penalty?

               
To explain this, let us take two scenarios.

             
fixed deposita) You hold your existing deposit till maturity. At the rate of 7% at the end of 1 year you will receive an amount of Rs 7185.9 as the gross compounded interest amount.

                
b) If you withdraw your deposit prematurely in the first three months and then reinvest the remainder at the higher interest rates, (assuming the same maturity date as the first scenario) at the rate of 7.75%, you will earn a total interest amount of Rs 6786.5 for the total period.

                      
Comparing scenario a) and b), you will realize that though the deposit rates have increased by 0.5% you have actually benefitted from holding on to your deposit till maturity rather than breaking it mid-way.

                    
You may argue with me that this is assuming that the bank has a pre-term penalty clause.  What if your bank does not?  If we take scenario a) without the pre-term penalty of 1%, the effective interest you will receive will be Rs 7051.31; this is still marginally lower than the interest you would receive had you kept your deposit on till maturity. 

                 
So, the next time you think of pre-terminating your harmless fixed deposit, do the math first and then make your choice! Happy Investing!


For more details on fixed deposits, please click here

               

Use InvestmentYogi’s free online Financial Planner and Financial Calculators to assist you in managing your Financial Portfolio.

           

The author, Daisy Fernandes has a Masters in Management from SP Jain, a Banker by profession and currently pursuing CFP certification.

            

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Published Dec 29 2010




Comments

Comments

 

The Money Paradise said:

One should always be careful when withdrawing money from FDs from banks just to enjoy or earn some higher interest rate. Everyone who plans to withdraw from existing Fixed deposits to  earn higher interest rate should check the  effective interest rate in their case than the notional interest rate by deducting all the losses from withdrawing money prematurely from FD.

January 3, 2011 1:59 PM
 

rakesh kumar jain said:

Dear Sir/Madam,

I guess there a small problem with the example. If the FD was invested for 1 year &

broken pre-maturely then example holds good. But, possibly if FD was invested for 3 years & broken after 3 months then possibly one will benefit by this pre-mature

withdrawal & reinvestment. So, I guess depending on period of investment & after

how much time the FD is broken, the final gain/loss will take place. Kindly comment.

Thanking you. Best regards, RAKESH (rkj951@yahoo.com)

January 9, 2011 9:40 PM
 

Mind Your Money said:

Even if the original FD was for 1 year, one can benefit if you consider what may happen after the original maturity date. If one renews the FD and the interest rates have come down by then, then it may be better to break the FD and lock in the higher interest rate for a longer term.

January 12, 2011 2:24 AM

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