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The rapid fall in inflation in the last couple of months is the first indication that the tide is slowly turning in the debt market. Interest rates are now expected to start their downward move and it's now only a question of when this happens. This requires a specific strategy for debt investments. A key component of this entire exercise would be the fixed deposit (FD) investments that would require the investor to take a measured call on how they would actually go about the whole process. Here is a closer look at how investors can gain from effectively by planning for their bank FDs.
Why FDs?
For someone who does not want any kind of uncertainty with regard to his or her investments, FDs would be the right choice. Once the initial investment is made, there is little to worry about and one can then concentrate on other aspects of the whole portfolio.
Lock in for a longer time
One of the key points with a bank FD is that the investor can lock themselves into a specific rate of interest when they make an investment into the instrument.
This means that if they invest in, a three-year FD at 9 per cent per annum, then the interest rate remains at this level for the entire duration of the deposit even if rates change in the interim period.
The changes in the FD rates will impact only prospective investors. Those who are already invested in FDs will get rates that were applicable when the investment was made.
Since interest rates are expected to go down, the smart strategy for investors today is to ensure that they lock themselves into a fixed deposit for a longer time period so that they continue to earn higher rates of interest even if rates were to go down.
The trend on the inflation and interest rate front can change very quickly and, hence, investors should ensure that they are able to earn a higher rate of return for the maximum time period that is possible.
How long is preferable?
The next question is how long should investors lock in their money in FDs? Usually a period of two to three years is taken for a longer-term view. But given that interest rates could move down from the current levels, one can look at a longer time period, of say five to seven years. If you are getting a good rate of interest for this time period then it makes sense to invest the money and enjoy the benefits.
The worry with taking a shorter-term deposit is that you would have to reinvest the amount as the deposit matures. The rates prevailing at the time of reinvestment may be less, which could lead to a future loss of income. However, by locking into higher rates now, you can ensure a positive real rate of return at a time when inflation starts to ease.
Outlook on interest rates
Currently, a three-year FD would fetch you anywhere between 8.5 per cent and 9.25 per cent, depending on which bank you choose. In case of some banks, a five-year term deposit offers a higher rate than a three-year deposit, while in case of others, the three-year deposit may be offering the peak rate. The rates offered by banks depend on the liquidity available with each bank, their requirement for funds of that tenure as they try and match the loans of the same tenure and competition. So, research the rates offered by various banks before choosing which bank to put your money in.
As the inflation situation eases, interest rates are likely to fall in the coming months. There already has been a realignment of the rates by several banks. They have reduced rates in some time buckets, while increasing it in some others. Most of the realignment is taking place in the shorter-term tenures.
For instance, State Bank of India has raised the rate on FDs of one to three years, but reduced it on FDs of 180-210 days by 25 basis points. More banks are likely to follow suite. And a rate cut by the Reserve Bank of India would put further pressure on FD rates. So, the overall outlook is pointing towards a fall in interest rates in the coming months.
Taxation
One important factor to consider when it comes to investing in FDs is the taxation. The interest earned on FDs is taxable, as per the income slab of the investor.
The interest earned is added to the income tax, under the head income from other sources and this gets taxed at the applicable tax-rate for the investor. For example a person who falls into the highest tax-bracket would find that the tax rate would work out to 30 per cent plus surcharge.
Earlier taxation was a big drawback for FDs. But post this year's Budget, FDs are more-or-less on par with debt MFs when it comes to taxation. Now any debt MF that is redeemed before three years attracts short-term capital gains. This would be taxed as normal income at the marginal rate of tax and, hence, this would be as per the slab that the individual falls under.
At the same time the long-term capital gains, which is for investments held for a period of more than three years, the tax rate would be 20 per cent with the benefit of indexation. This could help investors who fall in the highest tax bracket and want to invest for a longer period. For the dividend option the dividend distribution tax burden works out to slightly more than 28 per cent.
However, there is no certainty about the earnings from debt MFs, since they are marked-to-market and could offer higher returns than FDs. Hence, a direct comparison with the fixed deposit rates would not be possible as returns here would depend upon the market conditions.
Also, remember than even if bank cuts Tax Deducted at Source (TDS), you will still have to pay tax on the interest as per your income slab. The bank will cut TDS at 10 per cent. If you fall in a higher tax slab, you will have to pay the difference. Those of you who have no other source of income can submit Form 15G stating the same. The bank will then not cut TDS on the interest. Senior citizens must submit form 15H to avoid TDS.
The author is a certified financial planner
