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Should you break your current Bank fixed deposit and reinvest?

The rate increase is good news for FD investors. But think before you break your FDs


   The only segment of investors who have something to rejoice about in the present times of ever-increasing interest rates is the fixed deposit (FD) holders. FD holders are having a good time. In fact they are in a fix. With frequent rate increases, their old FDs tend to give a lower return compared to the existing interest rates.


   The interest rates can go up to 10-12 percent on FDs in the coming weeks. And it is a safe investment. Bank FDs are a secure mode of investment, giving decent and periodic returns. In fact, in case you opt for the cumulative option, the yield is even higher.


   You just need to factor in the tax part. The interest earned on a FD is subject to tax. You have to pay the applicable tax on in. So, on a FD giving an interest of 10 percent, for an investor in the 20 percent tax bracket, the effective rate of interest is eight percent. Still, it is a good bet. In fact, the returns on these fixed rate instruments is much better than the stock market's returns right now, which is variable, uncertain and prone to risks. An investor seeking fixed income security can lock into a FD. You can get a secured interest income for up to five years. Most banks offer FDs up to five years. Without any risk or uncertainty, you can plan your cash flows.


   The returns from the stock markets may be high, but they come with a risk. Moreover, in times of need, you may not be able to dispose off your stocks, if the markets are down at that point in time. On the contrary, in case of an urgent need, you can prematurely cash your FD and get back the principle plus applicable interest.


   The Reserve Bank of India (RBI) increased the key policy rates by 50 basis points, leading the repo and reverse repo rates to eight percent and seven percent respectively. With this increase in interest rates, the impact may be felt immediately. The quantum of rate increase will be decided in the respective asset-liability committee meetings of banks. The increase could range between 25 basis points and 50 basis points. In the immediate term, the rates on short-term deposits deposits with a maturity period ranging from one week up to one year - will increase. Longer tenure deposits may also follow suit. There is more competition for short-term funds from banks and mutual funds. So, the interest rates will go up sooner in this segment.


   Before deciding to break up your existing FDs and go for ones with higher interest rates, you should make a calculation of the returns and check whether it is beneficial or not. Banks now levy a one percent penalty on premature encashment of a FD. Also, the interest rate applicable is the one that is applicable for the shorter tenure and not the original rate of interest you signed up for.

How It Works?


HERE is a simple case study that shows you how it works when you break up an existing FD for another one at a higher rate.


FD amount: Rs 10,000 Term:

One year Interest rate: Seven percent


If you decide to break this after four months:


Interest rate for four months: Five percent You earn (5-1) four percent for four months: Rs 133 Amount reinvested: Rs 10,133 at eight percent Interest earned for the remaining eight months: Rs 540 Total interest earned: Rs 673 (Rs 540 plus Rs 133) Therefore, effective interest: 6.73 percent


In this case, it is lesser than the original interest rate of seven percent.


If you decide to break this after one month:


Interest rate for one month: Four percent You earn (4-1) three percent for one month: Rs 25 Amount reinvested: Rs 10,025 at eight percent Interest earned for the remaining eight months: Rs 735 Total interest earned: Rs 760 (Rs 735 plus Rs 25) Therefore, effective interest: 7.6 percent


In this case, it is higher than the original interest rate of seven percent.
So, you need to compare the costs and returns before deciding on breaking a FD and reinvesting.

 

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