Should you opt for one large fixed deposit or multiple smaller FDs?

With the RBI pausing the rate hike cycle, and deposit rates nearing their peak,  several financial institutions are offering 7-8% interest rates on  fixed deposits now and some small finance banks are even offering 8.5% interest. Many investors are now considering investing their surplus funds into FDs. But before you invest your entire funds in one single FD, consider these factors:

Spread your investment across multiple FDs with different maturity dates

1. For earning better returns, you can spread your investments across multiple fixed deposits with different maturity dates instead of locking all your funds in one fixed deposit for a longer period. This approach allows access to funds without breaking the entire investment. If you have Rs  5 lakh in your savings account, you can make a single deposit but you will have to lock into one tenure at one rate. This would mean low returns. On the other hand, with laddering, you can split the money into five deposits at different rates. Each deposit will renew at different intervals of one, two, three, four and five years. It will ensure better average returns. For example, the one-year deposit will return 4.5 per cent. The two- and three-year deposits will return 5 per cent. And the others will return 5.7 per cent.

 

Adhil Shetty of BankBazaar explains this with the help of an example: Assume you have a total investment amount of Rs 10 lakh that you want to invest in fixed deposits. You decide to divide this amount into four equal parts of Rs 2.5 lakh each. Thereafter, you can invest in fixed deposits with varying maturity periods.

Here's how you could structure your fixed deposit:
 

FD 1- Rs 2.5 Lakh for a 1-year

This fixed deposit will mature in one year and provide you with a lump sum amount at the end of the tenure.
 

FD 2: Rs 2.5 Lakh for 2 years

This fixed deposit will mature in two years, providing you with a higher interest rate compared to the one-year deposit. If you need funds after one year, you can still rely on the maturity of FD 1 deposit.
 

FD 3: Rs 2.5 Lakh for 3 years

This will mature in three years, further diversifying your investment. If you need funds after one or two years, you can rely on the maturity of FD 1 and FD 2 deposits.
 

FD 4: Rs 2.5 Lakh for 5 years

This fixed deposit will mature in five years, providing you with a higher interest rate as compared to shorter-term deposits. It acts as a long-term investment, and if you need funds before its maturity, you can rely on the maturity of FD1, FD2, and FD 3 funds.

Such a strategy is also known as laddering where you can spread your fixed deposit investments across different maturities to maximise returns and maintain liquidity.

"As each fixed deposit matures, you can choose to reinvest it or use the funds as per your financial needs. If your FD is locked at lower interest rates, you may use the funds to reinvest at higher interest rates provided you have done your calculation regarding investment returns," said Shetty.

 The thumb rule is - when the rates are high, go for longer tenures with your deposits. When they are low, ladder them and wait for higher returns.

2. Insurance of FDs capped at Rs 5 lakh per account holder per bank

The Deposit Insurance and Credit Guarantee Corporation (DICG)C provides deposit insurance of only Rs 5 lakh per account holder per bank, including principal and interest. Therefore, if someone wants to invest more than Rs 5 lakh, it's advisable to split among multiple banks. Having multiple FDs across different banks, implies your risk is spread out evenly. Even if one bank goes bust, the impact is restricted. Moreover, investing across issuers can help you tap better interest rates too. If you choose to keep all your money in one FD with one bank, then you cannot avail special rate FDs of other banks.

"Investors should note that the Rs 5 lakh  insurance limit includes FDs and savings account balances. Hence, if someone has Rs 1 lakh in a savings account, only Rs 4 lakh in FD would be covered under insurance. If an investor wants to invest only with one bank, he can increase his insurance coverage through joint FDs. For example, he can have a Rs 5 lakh FD in his name and another Rs 5 lakh in joint FD with himself as the first beneficiary and his spouse as the second beneficiary. He can opt for another FD of Rs 5 lakh with his spouse as the first beneficiary and himself being the second beneficiary. In this case, the entire corpus of  Rs 15 lakh would be covered by insurance," said Anshul Gupta, Co-founder and Chief Investment Officer, Wint Wealth.

3. Premature withdrawal of FDs for reinvestment can result in varius penalties 
 

FDs offer the option of premature withdrawal but banks charge a penalty for closing the deposit before the tenure ends. These penalty charges typically range from 0.5% to 1% of the interest rate. When you break your FD prematurely, you lose out money that could have been compounded as interest. Some major banks such as HDFC Bank charge 1% for premature withdrawal. On the other hand, ICICI Bank charges 0.5% to 1% and State Bank of India charges 0% to 0.50% of the interest rate.

The different penalities decoded :

The penalties for breaking a fixed deposit before its maturity can vary depending on the terms and conditions set by the banks where the deposit is made. Here are some common penalties that may be imposed, according to -Pallav Pradyumn Narang, Partner, CNK.
 

1. Reduced Interest Rate: When you break a fixed deposit prematurely, the bank may lower the interest rate that was initially offered. The reduced rate is typically applied from the date of deposit until the early withdrawal date. The interest rate payable will be 1% less than the actual rate of interest applicable for the period for which the deposit has remained with the bank, prevailing as on the date when the deposit account was opened.
 

2. Loss of Interest: In addition to reducing the interest rate, the financial institution may also forfeit a portion of the interest earned on the fixed deposit. This usually ranges between 0.5% and 1%. Some banks do offer premature withdrawal facilities with zero penalty charges. The exact amount forfeited can vary depending on the bank's policy.
 

3. Penalty Fee: Banks may charge a penalty fee for early withdrawal of a fixed deposit. The fee is usually a percentage of the principal amount or a predetermined flat fee.

If you do decide to break the FD prematurely and reinvest say Rs. 30,00,000 in 5 smaller FDs to  avail a higher interest rate, there are a few factors to consider. 
 

Firstly, evaluate the interest rates offered by the new FDs you plan to invest in and compare them to the current rate of the old FD. Make sure that the potential increase in interest  justifies the penalties and reduced interest earnings resulting from breaking the old FD.

Ritesh Sabharwal, a certified financial planner, explains this with an example: If you have opened a fixed deposit of Rs 1,00,000 at an interest rate of 7 per cent two years ago, and you decide to break than FD after one year, the interest rate for a 1 year FD back then was 6%, therefore when you pre-close your FD after 1 year, the bank will pay you at 6% and not 7%.

Break your FD only when it is not close to its maturity and there is substantial time left for the deposit

As a rule of thumb, if you have fixed deposits which are new or more than one year away from maturity and are at atleast 1% or higher differential rate of interest from the current offering, it may make sense for you to break the FD and create a new one at a higher rate. But those who are sitting on surplus funds in their bank account should ideally open an FD now and take advantage of the higher interest rate.

Understand the tax implications:

Pursuant to Section 194A of Income Tax Act,1961, TDS of 10% is deducted on any interest  payment over  Rs 40,000 made by a Banking Company, a co-operative society carrying on  banking business or Post Office.
 

a. This shall be deducted on the whole interest amount

b. Threshold for Senior Citizen (i.e., Age > 60 years) shall be Rs 50,000

A Ballpark figure of amount to be invested in each FD to avoid this TDS will be (400,000- 500,000), assuming gross rate of return of 8%-10% p.a.
 

Narang explains this with the following example:  Suppose Mr. Ram (Age 49 Years) has made a fixed deposit with ICICI Bank 

amounting to Rs 512,500 yielding a ROR of 8%. The annual interest on the deposit will amount  to Rs 41,000. The bank will deduct TDS of 10 per cent  i.e., Rs 4,100 .