How does Fixed Deposit Work
03 Jul 2019
A fixed deposit is one of the most popular investment avenues in India, particularly among risk-averse middle class investors. How does fixed deposit work? Let’s take a look.
How does a fixed deposit account work?
For that we have to understand that there are two parties involved here. One is the bank and the other is the customer. Banks need money, which they lend to borrowers from whom they charge interest. Banks obtain that money from its customers mainly through various accounts – current, savings etc.
One way of obtaining that money is through fixed deposits for which they offer certain rates of interest. The funds that they get is lent to borrowers for a slightly higher rate of interest. The difference between the interest rate on FDs and on loans is called the spread, which is the bank’s earnings.
How does fixed deposit work in India? If you have some spare cash and want to invest in fixed deposits, there are many options available for you. You can deposit money for periods ranging from a few days to a few years. Of course, the interest rates for shorter periods will be lower than those offered on fixed deposits of longer maturities. For example, if you want an FD for 30 days, the interest rate could be around 6 percent. If the deposit is for a year, the interest rate could be 7 percent.
The interest rates charged by different banks vary, so you might have to do a comparison to find the best rate. However, differences tend to be small. Smaller banks, like cooperative banks, may offer higher rates of interest than the large banks. However, you must remember that there is a direct correlation between risk and returns. High interest rates will always mean a higher level of risk.
Whether or not you choose to invest in a fixed deposit depends on how much returns you are satisfied with, and the amount of risk you are prepared to bear. Generally, returns on fixed deposits are lower than other investment avenues like equity, but the risks too are lower.
Advantages of fixed deposits
Hedge against inflation
Remember, the real value of your capital is being constantly eroded by inflation. If you have Rs 1 lakh and the inflation rate is 5 percent, the value of that Rs 1 lakh will become Rs 95,000 the next year. So depositing that cash in a fixed deposit will preserve the value of that cash.
Fixed deposits are less risky than other investment avenues like equity. Moreover the Deposit Insurance and Credit Guarantee Corporation, a subsidiary of the Reserve Bank of India, insures FDs up to Rs 1 lakh (principal and interest), so your money is perfectly safe up to Rs 1 lakh.
Interest rates are fixed beforehand, so you don’t have to worry about what you’ll get when the FD matures
Now that we have explained what is a fixed deposit and how does it work, you can go ahead and open one. The process is straightforward and simple. If you have a savings account with your bank, you can open an FD with just a few clicks of your mouse. You can open an FD in other banks as well, but you have to open a savings account first. FDs are a good investment, and should be part of any investor’s portfolio.
Fixed Deposits- Features, Benefits, Disadvantages
A fixed deposit is one of the most popular investment options in India. Several people consider fixed deposits as the best investment option and invest a significant portion of their savings in this instrument. But what is a fixed deposit?
A fixed deposit is a type of deposit in which a sum of money is locked for a fixed period of time. However, the tenure for the fixed deposit is decided by the person who invests his funds. This tenure could be anywhere from a few days to several years. In return for locking in these funds, fixed deposits pay the depositor a fixed rate of interest. All banks offer fixed deposits at different rates. Opening a fixed deposit is extremely simple and can be done both online and offline. To understand whether investing in a fixed deposit is the best option, we need to look at the advantages and disadvantages of fixed deposit account.
Let us examine the fixed deposit advantages and disadvantages.
Advantages of Fixed Deposit:
Assured rate of return:
The major reason why people prefer investing their funds in a fixed deposit is the assured rate of return. Once you invest your funds in a fixed deposit account, you can be guaranteed of receiving the stated rate of return. Banks publish the fixed deposit rate of interest on their website and in bank branches which makes it easy for a customer to ascertain how much return he will get. Banks also have a fixed deposit interest calculator on their websites where a customer can calculate the interest he will receive on investing a particular sum of money for a particular period of time.
Tax threshold for interest:
Banks are not mandated to deduct tax on any interest until it crosses Rs. 10,000. This means unless the total interest earned by a customer on different fixed deposits totals Rs. 10,000, the bank will not deduct any tax. This provides comfort to small deposit holders.
The tenure for a fixed deposit is flexible and depends on the deposit holder. Each bank has their own minimum tenure rules however, the final decision can be taken by the deposit holder. It is also possible to decide whether to redeem the fixed deposit or to extend it for the same period of time.
It is relatively easy to liquidate a fixed deposit. For FDs booked online, they can be liquidated online via net banking as well. Otherwise, most bank branches have a form to liquidate the FD.
Loans against fixed deposit:
An FD is a dependable instrument to keep in case of financial emergencies. Taking a loan against a fixed deposit is very easy. You can take a loan up to 95% of the fixed deposit amount depending on the bank. This makes it a dependable investment.
Disadvantages of Fixed Deposit:
Reducing interest rates:
Even though fixed deposits have a lot of advantages, the interest rates do not move in line with inflation. This means in some cases, they may actually earn less than the inflation rate. The interest rates for fixed deposits have been falling in recent times which has reduced the attractiveness of this investment.
Locked in funds:
Fixed deposits lock in your funds for a fixed duration. These funds are not available for you to use unless you withdraw the funds prematurely. Fixed deposits are not at all liquid and cannot be converted into cash easily.
Penalties on withdrawal:
Banks charge penalty to the depositors who withdraw their fixed deposits prematurely. This penalty is in the form of a reduced rate of interest.
No tax benefit:
The interest earned on fixed deposit is added to the taxable income of the deposit holder. There is no deduction on any interest earned. However, senior citizens get a deduction up to Rs. 50,000 on interest.
Fixed interest rate:
The rate of interest on a fixed deposit remains the same for the entire duration of the fixed deposit. Even if the rates increase, the bank does not pay additional interest to the deposit holder.
After looking at the advantages and disadvantages of a fixed deposit account, it is clear that this is an instrument for people who do not have much of a risk appetite. If you’re a person who likes to see fixed income in his account, then this is the instrument for you. The earnings from this form of investment are limited. However, banks have a sweep in facility where excess funds from a savings account can be diverted to a fixed deposit until the customer needs these funds. By enabling this feature, you can increase the returns from your fixed deposit account.
How is Interest on Recurring Deposit Calculated
A recurring deposit is one of the best ways a small investor can invest funds and grow them. In a recurring deposit, a fixed amount of money is invested at a fixed duration for a fixed period of time. These installments all mature on the same date. Essentially, a recurring deposit is like having multiple fixed deposit investments, all of which mature on the same day.
You do not have to wait till a recurring deposit matures to find out the interest that you will earn on a recurring deposit. If you’re wondering how to calculate RD interest, then read this guide.
How to calculate recurring deposit interest using a calculator:
With the digital revolution in banking, the services offered by banks have undergone a sea change. It is no longer necessary to invest in a recurring deposit to find out how much you will earn on maturity. There are several banks that have a recurring deposit interest calculator on their website. This tool addresses how to calculate interest on RD account.
To calculate the RD account interest, you need to input the following:
Rate of interest
Period of investment
After putting in these details, you need to click submit and the calculator will show you the maturity amount. Using this calculator can help you find out the total interest you can earn on a recurring deposit instantly. It is very essential to use this calculator to find out the maturity amount and the interest as it can help you find out how much to invest if you’re raising funds for a particular goal. One important thing to remember is that banks compound interest quarterly on these deposits.
If you’re investing for a senior citizen, the rate of interest on such deposits is higher.
How to calculate RD interest manually?
If you’re wondering how to calculate compound interest for recurring deposit, you can use this formula:
M = P*(1+R/N)^Nt
Where M = Maturity amount. P = Principal amount or the installment amount R = Interest rate in decimal, convert interest rate into decimal by dividing it by 100 T = Time duration in months t = Time duration in years N= compounding frequency (since it is quarterly, it will be 4)
This formula is the formula for calculating compound interest. Banks generally compound interest quarterly on deposits. However, to calculate compound interest on recurring deposit, the balance at the beginning of the quarter is considered. So, if you open a recurring deposit between a quarter, simple interest is calculated for the months till a new quarter begins and from the new quarter, compound interest is calculated. This is why there may be a slight difference between manual calculation and the amount that a holder may receive on maturity. Important points to remember about recurring deposit interest:
Interest on recurring deposit is taxable. This interest will be added to your taxable income and you will have to pay tax on it based on the slab you are in.
Your bank will deduct tax if the total interest on recurring deposit exceeds Rs. 10,000 in a year. You can submit Form 15G/15H declaring that your income won’t be in the taxable slab. On submission of this form, the bank won’t deduct tax on your recurring deposit income.
Senior citizens get a deduction on interest earned through recurring deposits under Section 80TTB up to Rs. 50,000. Section 80TTB gives a deduction on interest income from savings account interest, fixed deposit interest, recurring deposit interest etc.