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Investing in fixed deposits: Watch out for that penalty

Fixed deposit investors have a reason to cheer. With almost all banks increasing the fixed deposit interest rates across the board they can expect better returns in 2011.

But 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, and 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.

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The author, a masters in management from SP Jain, is a banker by profession and currently pursuing CFP certification

Investing in fixed deposits: Watch out for that penalty

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 you 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 premature liquidated deposit. This is to the tune of 1 per cent 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.

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Investing in fixed deposits: Watch out for that penalty

Suppose you invested Rs 1 lakh in a fixed deposit for 1 year at the rate of interest of 7 per cent and the rates were revised to 7.75 per cent in the month of December. If you are thinking of reinvesting that Rs 1 lakh at 7.75 per cent then here 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 per cent and deduct 1 per cent as penalty.

This means that 3.25 per cent is the rate of interest that the bank will pay you on your Rs 1 lakh FD. This means that you will receive Rs 812.5 as interest for the 3 month period.

If you wish to know your bank's deposit policy, check on their web site. 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.

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Investing in fixed deposits: Watch out for that penalty

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.

You hold your existing deposit till maturity. At the rate of 7 per cent at the end of 1 year you will receive an amount (interest plus principal) of Rs 7,185.9 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 per cent, you will earn a total amount (interest plus principal) of Rs 6,786.5 for the total period.

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

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Investing in fixed deposits: Watch out for that penalty

You may argue 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 per cent, the effective amount (interest plus principal) you will receive will be Rs 7,051.31; this is still marginally lower than the interest you would receive had you kept your deposit 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!