Explainer | Why laddering fixed deposits makes for better investments
Laddering your fixed deposit also help you take care of the re-investment risk.
January 30, 2019 / 09:15 AM IST
Moneycontrol PF Bureau
Fixed deposits serve the purpose of achieving short-term goals, especially if you are in low income tax slabs. The fixed deposits being low-risk products work better for individuals with low-risk appetite, though they may not beat inflation. In addition to credit risk, there are two risks that investors face while investing in fixed deposits — liquidity risk and re-investment risk.
If you invest in fixed deposits issued by sovereign entities such as India Post, nationalised banks or even good names in private sector, then credit risk is negligible, if not entirely eliminated.
However, an investor can’t ignore liquidity needs. Laddering can address it. Laddering means you spread your fixed deposits across timeline. For example, if you have Rs 5 lakh to invest in fixed deposits make five fixed deposits maturing over one, three and five years, provided your financial goals permit. If you keep doing this at regular intervals, you will have fixed deposit maturing at regular intervals.
Even if you need money in the interim period, you can opt for pre-mature withdrawal only to the extent of the money required. For example, assume that for a medical emergency you need Rs 2 lakh. If you have one fixed deposit of Rs 5 lakh, and you break it you will be subject to penal rate of interest for entire Rs 5 lakh. Instead if you have five fixed deposits of Rs 1 lakh each, you may choose to break only two fixed deposits. Remaining money keeps earning interest at the rate that was contracted at the time of booking fixed deposit.
Laddering your fixed deposit also help you take care of the re-investment risk. It means the risk of a possibly lower return you will get at the time of reinvesting your money. If all your money is invested in one go, then you may have to book a fixed deposit at a much lower rate if the interest rates in the economy are at cyclical low. This may result in a significant cut in your cash-flows.
For example, if you have had put all your money in one-year fixed deposit of State Bank of India in August 2008 at 10% (rate prevalent back then) and maturing in September 2009, then at the time of maturity, you would have had to reinvest all your money at 6.5% if you choose to stay with State Bank of India.
To overcome such a situation, it is better to invest at varying point of time and build a ladder. This ensures not all your money comes for re-investment at a given point of time.