Aug 17, 2009

Investing in Bank FDs – Interesting Interest Information

Photo by juliebee

In India, bank fixed deposits (FDs) also called ‘Term Deposits’are still the top-most choice for investing.

While investing in the FDs, an investor has to take into account various considerations such as returns, tax impact, liquidity and safety. But the most important factor among all the variables is the rate of interest offered by a bank on fixed deposit.

Therefore, this post talks about the interest rates offered by various commercial banks on fixed deposits and some interesting information hidden behind the interest rates displayed by them.

For instance, interest rates offered by various banks vary a lot; within a bank there is too much variation in interest rates offered for different durations of deposits; there is also variation in manner of interest calculation for short term and long term tenures of FDs; manner in which interest rates on deposits are displayed also differ among banks and above all the interest rate is not the same thing as yield.

Here’s a list of such interesting facts about interest rates on bank fixed deposits (FDs) which ultimately affects the return earned by an investor:


Bank FDs – Interesting Interest Information
1. It is wrong to assume that greater the FD tenure, higher will be the rate of interest. It is not so. Sometimes short duration interest rates are higher than long duration rates (due to tighter liquidity conditions).


2. Even a single day difference in the FD period can make a huge difference in your interest income due to wide variation in the FD interest rates. For instance, let’s say you are planning to invest in two FDs, one for 2 months and another for 3 months and your bank is offering, say, 6% on FDs for the duration of 31-60 days, 6.5% on 61-90 days deposits and 7% for 91-180 days deposits. In this case it would be outright foolish to invest in FDs for 60days and 90 days. It makes greater sense to go for 61 days and 91 days fixed deposits and earn extra interest of 0.5%.


3. Many banks offer special deposit rates for a particular tenure which are quite higher than deposit rates for other durations (both higher as well as lower tenures).

For instance, HDFC bank is currently (as on August 17, 2009) offering following interest rates (p.a.) on FDs:

91 days to less than 6 months 1 day------> 4.50%
6 months 2 days to 6 months 15 days ----> 5.50%
6 months 16 days-----------------------------> 6.00%
6 months 17 days to 9 months 15 days---> 5.50%


Supposing that you’re planning to invest in an FD for 6 months, if you are not careful and fill the FD form for either 6 months or 180 days, you can straightforwardly lose 1.5% p.a. The right choice is to invest in FD for 6 months 16 days.

But why do banks so much juggle with interest rates on fixed deposits? ‘Cost of funds’ simply can’t be the reason. Perhaps, like other financial companies they also practice confusopoly.

So you need to be extra careful. It is always better to check the latest deposit rates online (as the rates are also changed frequently in addition to variation in interest rates for different tenures of FDs) instead of relying on the bank branch officials, who might not guide you properly or in fact misguide you.


4. The interest rates offered on fixed deposits are annual rates (% p.a.). So, if a bank is offering you 7% rate of interest for 90 days deposit, it means that 7% for 365 days to be paid for 90 days i.e., you get 1.726% (7/365*90) for 90 days.


5. The rate applicable for a ‘monthly interest payment’ option is discounted rate over the standard FD rate. For example, if you invest in a FD for one year offering interest @ 12% p.a. (assuming no quarterly compounding) and choose the maturity option, you’ll get interest @ 12%. However, if choose monthly payment option you won’t receive interest @ 1% (i.e., 12/12) per month. Because, if you receive interest @1% per month, the effective annual rate on the FD becomes 12.68 per cent. Therefore, in case of monthly interest payouts, the bank discounts the annual interest rate; in the above example, the discounted rate of interest per month works out to be 0.9488% approximately. If you’ve a fixed deposit of Rs 1 lakh, you will receive monthly interest of Rs 949 and not Rs 1,000. So the total interest to be received by you at the end of one year will be Rs 12,000 for maturity option and Rs 11,388 for monthly payment option.

However, this discounting rule is not applicable if the maturity period itself is of shorter duration. For instance, if the bank is offering, say, 12% p.a. on one month fixed deposit, then you’ll receive interest @ one per cent (12/12) for the one month deposit (i.e., effective rate of interest earned by you is 12.68%).

It follows from the above that, in case of shorter term deposits (i.e., less than one year), your effective rate of interest is more than the stated rate of interest).

Let me explain it in another way. Continuing the above example, when your monthly deposit will mature, you’ll receive Rs 1,01,000. If you again reinvest it for another month, your interest for next month will be Rs 1,010 and if you continue reinvesting at the end of every month (assuming there is no change in interest rates), you’ll finally end up with Rs 1,12,680 in your pocket at the end of one year earning annualized yield of 12.68%.

However, it is not practically feasible even if you keep on reinvesting because of too frequent changes in interest rates. In the above example, the actual returns earned by you at the end of the year will be either greater or lesser than 12.68%.


6. The interest rate offered doesn’t truly reflect your return. The true measure to reflect the returns from FDs is the yield.

For instance, even if the interest rates on two FDs are similar, yield may differ because of frequency of compounding. A 10% rate of interest per annum payable quarterly is better than a same interest rate payable either half-yearly or annually.

In India, most banks offer you quarterly compounding for FDs of greater than 6 months duration and calculate interest at maturity as simple interest for FDs up to 6 months tenure.

The effective yield in case of quarterly compounding (assuming 10% rate of interest) comes to be 10.38%, for half yearly compounding it works out to be 10.25% and for annual compounding it remains unchanged at 10%.

Similarly, if the interest rate of 5.8% p.a. is compounded quarterly then effective yield / annualized yield works out to be 5.927%. However, as per IDBI Bank it is 6.11%.

As per IDBI Bank website (as on 16 August 2009),

“the interest rate for a 2 year + 1day deposit is 5.80% p.a. but the effective yield is higher at 6.11% p.a. on account of reinvestment of interest earned”


Isn’t it outright lie and intentional misleading of investors /customers?

So, again my advice to you is to remain vigilant and not to rely on the banks (or their websites) blindly and either work out your own calculations or cross-verify the information provided to you by them.

For any other doubt regarding working of interest rates on bank fixed deposits, just write in the comment box below.


Also see:

1. 10 Tips for PPF investing

2. Should You Invest in NCDs?

3. Gold ETF – The Best Way to Invest in Gold

4. NCDs - Top 10 FAQs

5. Bank FD: Consequences in case of Death

3 comments:

  1. Some clarity on Continuing FD in name of deceased as Interest rates locked in are good and not worth premature closing and reopening FD. How will Interest proceeds be taxable

    ReplyDelete
  2. Sudheer, to answer your query in detail I’ve published a separate post regarding continuity of Bank FD and its tax treatment in case of death. The link is given just above the comment section.

    ReplyDelete
  3. and moreover we are also liable to pay Tax on such interest income... And 30% goes in taxes... so we are virtually left with nothing

    ReplyDelete

You’re welcome to post a comment if you’d like to air your views, or if you’ve any further question to ask, but please stick to the topic and don’t forget to write your name.