How to get the most out of your fixed deposits as interest rates fall

Choose a higher compounding frequency, and invest across multiple tenures and banks

State Bank of India recently cut the interest rates on its fixed deposits (FDs) for the third time in two months. The new FD interest rates will be effective from May 12. Other banks are expected to follow suit. Those looking to invest in FDs should do so at the earliest before rates plunge further.

The ongoing crisis in debt funds has left investors with fewer options. Says M Barve, founder, MB Wealth Financial Solutions: “In a falling interest rate scenario, investors turn to debt funds, which usually offer higher post-tax returns. But given the troubles they are witnessing currently, many would prefer to avoid that route for some time.”

Interest rates on FDs have not bottomed out and could fall further. “This could be the last chance in some time for investors to get decent returns on FDs,” says Barve. 

Ladder your FDs: Currently, when interest rates within the economy are low, the only option most investors may be able to think of to earn a higher return would be to invest for longer tenures. But that would mean getting locked in for longer. One alternative is to ladder, which refers to breaking up a sum of money into parts and investing each in FDs of different tenures, instead of putting the entire sum in a single FD.

Pay heed to your liquidity needs when laddering. Says Raj Khosla, chartered accountant and managing director, MyMoneyMantra: “Create a ladder based on when you are likely to need the funds.” Here's how it works. Say, you want to invest Rs 3 lakh. Instead of investing the entire amount in a three-year deposit, break it up into three parts of Rs 1 lakh each. Invest the first part in a one-year FD, the second in a two-year deposit, and the third in a three-year deposit. A year down the line, the one-year deposit will mature. You can then reinvest that amount in a three-year FD, thereby creating the fourth rung in your ladder. When the two-year FD matures, you can reinvest it for three years to create income in the fifth year. 

 

 

Laddering helps you commit to a longer-term while retaining some liquidity. Since your money matures at regular intervals, you have the option to use it if you have a need. 

Most importantly, laddering enables investors to tackle reinvestment risk. This is the risk that your FDs may all mature at a time when interest rates are low, forcing you to reinvest at a low rate. Says Barve: “Laddering uses the concept of time diversification. It's more of a strategy than a judgement.” Since interest rates tend to be cyclical, you can reinvest at different points and different rates, thereby averaging out the return you earn over an interest rate cycle. 

Laddering also reduces the loss you suffer when you break an FD prematurely, say, to reinvest in a new FD when rates have moved up. If you break an FD before its term expires, a part of the benefit of moving into a new FD gets lost.  

Look at the frequency of compounding: Besides interest rate and tenure, also check the frequency of compounding offered by your bank. Says Pranjal Kamra, chief executive officer, Finology: “One FD may offer monthly compounding while another may offer quarterly or semi-annual compounding. In FDs, more frequent the compounding, the better it is.”

The amount you receive will vary, depending on the frequency of compounding. Suppose that you create a Rs 1 lakh FD at 7 per cent per annum for two years. If the compounding is monthly, you will get Rs 1,14,981. If it is quarterly, you will get Rs 1,14,888. If it is semi-annual, you will get Rs 1,14,752, and if it is annual you will earn Rs 1,14,490. 

Explore the bullet mode: Those investing in a regular FD should explore the availability of this option. Says Khosla: “Look for a regular FD offering a good rate where they don't charge a fee for early withdrawal. While banks usually charge a penalty or pay a lower rate of interest on premature withdrawal, it is possible one may agree not to do so.” 

Opt for sweep-in FD: If you go for this option, then any amount in your savings account above a specified limit will get automatically swept into a fixed deposit and earn a higher rate of return. Says Kamra: “One of its benefits is that you don’t have to pay premature withdrawal charges if you dip into the money lying in the deposit.” Many larger banks offer this facility even on their current account. 

Diversify your FDs: Even if a bank is offering a better rate, it is so much easier to start an FD with your own bank, especially during the lockdown. Says Kamra: “These days people have three-four banking relationships. Check the rates offered by each of them. Starting a new banking relationship just for an FD can be tedious unless the bank lets you do the KYC online.” 

At the same time, don’t stick to one bank only. Says Khosla: “Invest the bulk of your FD corpus with larger banks and a smaller portion with a smaller one.” 

Experts are divided on whether you should invest in FDs of small savings banks or in company FDs for the higher rates they offer. Some believe the risk is not worth it. Others say it's okay to venture beyond the large commercial banks, provided you follow the barbell strategy. This is a concept which says the best way to strike a balance between reward and risk is to invest in two assets at the two extremes of the risk spectrum. Says Barve: “Keep the larger part of your investable corpus, say, 80 per cent, in bank FDs, and invest 20 per cent in AAA-rated company deposits, while avoiding above 10 per cent exposure to a single company.” At present, company FDs from HDFC, Bajaj Finance and Mahindra Finance are paying about 160-190 basis points higher than bank deposits. Some give even better rates if purchased online.