Exiting existing bank deposits for higher rates can hurt because of penalties
As the Reserve Bank of India (RBI) announced another round of rate increases, there is a set of people who are cringing at the rising interest rates. Not the borrowers, though this is probably the only scenario that strikes us with regard to such rate hikes. The other set of people are those who had locked in their funds in fixed deposits (FDs) at an interest rate lower than the prevailing one. With news that interest rates are likely to move northwards here on, there is much heartburn among the existing FD investors.
While switching your home loans to a lower interest rate, you must consider the fine print carefully. Similarly while switching your existing FD to one offering a better rate, there are several nuances to consider before making the decision.
Bank FDs have increased in the range of 0.25 - 1.5 per cent. However, there is also a penalty for exiting FDs prior to closure of tenure. This has to be carefully evaluated prior to any switching. For instance, if the FD is nearing maturity, it may not be prudent to opt for premature withdrawal. You will lose some interest income, since the interest rate is calculated on an annualised basis. The loss in the interest income may offset the gain you earn from higher deposit rates.
If the revised higher rates are able to compensate the penalties or the lower rate for the tenure one has invested for, one could switch. If the rates go up by 0.5 per cent and the premature withdrawal penalty is also 0.5 per cent, then there is no point exiting at this stage. Most banks typically charge one to two per cent on premature withdrawals of FDs. ALTERNATIVES TO FDs
Floating rate fixed deposits: Floating rate FDs are relatively a new concept. Mid-2010 saw the advent of these products. The rate of interest the FD holder gets will vary with the change in the bank’s base rate (the floating rate is held at about lower than the prevalent base rate) and the yield could be higher/lower than the FD, based on which direction the interest rate moves. In this case, if rates go up during the tenure of the deposit, FD customers will automatically benefit from higher rates. But the reverse is also true. If the base rate is revised downward, the rates on FDs will also fall, which is not the case with conventional FDs. Hence, if the outlook is that interest rates are likely to move northwards, then it makes sense to invest in these FDs. Many banks are now even providing an option of closing FDs prematurely and opening a floating rate deposit. In such cases, banks could even waive off or reduce the penalty on a case-to-case basis. Considering the funds continue to stay with the bank
Company fixed deposits: Company deposits often offer a higher rate of interest as compared to bank deposits, since they carry a higher risk. The safety and return on company deposits can be assessed, based on their rating; typically, the return on an AAA-rated company comes very close to that of a bank deposit, as the investor is assured of the company’s financial soundness. At times, public sector banks offer slightly higher returns than company deposits. And, they come with a FAAA rating by Crisil, indicating highest degree of safety regarding payment of interest and principal.
Fixed maturity plans: These are debt mutual funds which come with a lock-in; they invest in bank deposits in line with the tenure of the fund. Returns from FDs are taxed at normal rates (up to 30 per cent, plus cess), since these are assessed under the head income from other sources.
Gains from FMPs are considered as capital gains, where over the long-term, one gets the benefit of indexation and one ends up paying a maximum rate of 10 per cent, plus cess. Further, for an FMP with less than a year’s lock-in, it is suggested to opt for the dividend option, where the maximum taxation would work out to be minus 14.5 per cent. In both cases, FMPs prove more tax-efficient.
The writer is a certified financial planner
