5 factors to consider before choosing a fixed deposit

Despite the capital protection and income certainty offered by bank fixed deposits (FDs), the steep decline in interest rates in recent years, coupled with crises in Yes Bank and some co-operative banks, has reduced the attraction towards them even among many conservative investors.

However, there are still ways to benefit from these products. Here’s how you can make the most of bank FDs.

Prefer scheduled banks offering higher fixed deposit rates

The highest FD slab rates offered by a few private sector and small finance banks fall in the range of 7-7.5 percent a year, which is about 150-200 bps higher than the ones offered by most PSBs (public sector banks) and major private sector banks. These small finance banks and smaller private sector banks too are categorized as scheduled banks, which make the deposits opened with them eligible for the deposit insurance program of the DICGC, a subsidiary of the RBI.

The deposit insurance program protects cumulative bank deposits (including current, fixed, recurring and savings deposits) of up to Rs 5 lakh of each depositor, in each of the scheduled banks, from bank failures. Both the interest and principal components of the deposits are covered under the deposit insurance program for up to the said amount. For example, assume that a depositor has cumulative bank deposits of Rs 7 lakh and Rs 9 lakh in X Bank and Y Bank, respectively. In case both X and Y Banks fail, the DICGC will compensate that depositor Rs 5 lakh for deposits maintained with X Bank and another Rs 5 lakh for deposits maintained with Y Bank.

Having cumulative bank deposits of up to Rs 5 lakh with any of these small finance banks and small private sector banks is as safe as having deposits with any of the large private sector banks and PSBs. Risk-averse depositors can ensure highest possible degree of capital protection by spreading their bank FDs across multiple banks offering high-yielding FDs in such a way that their exposure to any of those banks does not exceed the Rs 5 lakh mark.

Avoid opening FDs of long tenure

 The Indian economy is in the midst of a falling interest rate regime due to a slowing economy and the successful efforts of RBI in reducing the market lending rates to push up the economy. However, questions have risen as to whether our economy has reached the bottom of the interest rate curve. Rising inflation, supply chain disruptions caused by the COVID-19 pandemic and any sharp economic revival, followed by an increased credit demand post-pandemic may cause broader market rates to increase in the future. This might lead banks to increase their FD rates as well. Opening FDs with long tenures may lock their FDs with very low interest rates for a long time. Hence, depositors should prefer FD tenures of 1-2 years, even if they have financial goals of longer time horizons.

Factor in your liquidity and short-term goals while choosing the FD tenure

Most banks penalize premature withdrawals of bank FDs by levying penalty of up to 1 percent on the effective interest rate of the FD. Effective interest rate usually refers to the lower of the original booked FD rate or the FD card rate applicable at the time of opening the FD for the period during which the FD remained in effect. This requires depositors to factor in liquidity and the time horizon of their financial goals while selecting their FD tenure. Not doing so will unnecessarily cost them premature withdrawal penalties during financial exigencies or maturing of an over-looked financial goal.

Split your FDs of similar tenures into smaller amounts

While some banks have started offering the facility of partial premature FD withdrawals, most banks are yet to offer this facility. As a result, any foreseen financial exigencies or cash flow requirements may force those with big-ticket FDs to close an entire big-ticket FD prematurely, thereby increasing the opportunity cost of losing out higher interest rates during a falling interest rate regime. To reduce this risk, depositors should prefer opening smaller ticket FDs instead of opening a single large FD.

For instance, if you are planning to invest Rs 10 lakh in a bank FD with a single bank, opening 9 FDs of Rs 1 lakh each and 2 FDs of Rs 50,000 each would provide more financial flexibility than opening a single FD worth Rs 10 lakh.

Consider your tax slab while making the investment decision

Tax liability of FD depositors does not end with the TDS deduction. FD interest income is fully taxable as per the tax slab of the depositor, except for the tax deduction under Section 80TTB on interest income up to Rs 50,000 to senior citizens. Hence, depositors should factor in their tax slab while estimating the net return from their FDs.

(The writer is CEO & Co-founder, Paisabazaar.com)