Fixed or floating rate deposits: which one to choose?
Term deposits are extremely popular among investors. They are low risk and offer guaranteed returns as well as easy liquidity. People make fixed deposits for safety of capital. However, the decision of the Reserve Bank of India to keep key rates unchanged has had an impact on deposit rates. FD yields have fallen, penalizing investors who rely on fixed income generating instruments. It also makes it difficult to continue investing in the DF.
FD rates at several major banks are around 5.25% per annum for terms of up to three years. With rising inflation, the real rate of return on deposits has turned negative, more so for tax-paying investors. In such a scenario, they are reluctant to place all of their cash in FDs. It becomes important for an investor to make movements of money which can improve his actual returns. While you can go for strategies like FD laddering, pick the most rewarding mandates, or buy corporate FDs for better returns, another alternative that can help is the variable rate term deposit system.
Banks offer two interest rate choices for FDs: fixed rate deposits and variable rate term deposits (FRTDS) which have a dynamic interest rate.
Take a look at it to make an informed decision.
Invest in term deposits
As the name suggests, term deposits are investments made at the prevailing fixed interest rate, which remains the same until maturity. For example, if you invest in a 5.5% DF for a three-year term, the rate will remain the same for the entire term, regardless of an increase or decrease in the bank’s interest rates at the end of the period. during this period.
If you want to liquidate your FD prematurely, you will have to pay an interest penalty which is generally 1%. Ideally, you should invest in term deposits after taking into account your cash flow needs or opt for partial withdrawals which reduce the interest penalty. When you go for a fixed deposit, you can also adopt the laddering strategy where you split your FD into smaller deposits created to mature at various intervals ranging from a few months to a few years. This will allow your FDs to mature at different times, allowing you to invest in the event of rising interest rates and minimizing the impact of falling rates. In the current scenario, when rates are expected to rise, you can opt for a fixed deposit with a shorter term and switch to a higher interest rate when it matures.
Invest in variable rate term deposits (FRTD)
FRTD interest rates are linked to the benchmark rate of a benchmark instrument. Consequently, they remain variable throughout the duration of the mandate and are revised according to the underlying reference rate. The benchmark rate is reset at regular intervals and therefore the interest on FRTDs is also reset at the same intervals. FRTDs are usually linked to benchmarks like Treasury bill rate, reverse repo rate, etc. For example, one bank offers three-year FRTDs with a 1% mark-up over the current repo rate (currently 4%). This means that if you book FRTDs for 3 years, you will earn returns at a rate of 5% per annum. However if the repo rate drops to 3% after 6 months, the rate on your FRTD will be revised to 4% pa
FRTDs work well when the interest rate is expected to rise in the near future. You can invest in FRTDs at the going rate to take advantage of interest rate hikes in the future without breaking your term deposits. Keep in mind that when the interest rate trend is down, FRTDs can gradually turn ungrateful.
FD vs FRTD: where to choose?
The interest rate offered on FRTDs is generally lower than the interest rate on FDs. It might be a good option to invest in FRTDs when you expect the interest rate to rise in the near future, exceeding the going interest rate offered on FDs and not falling below the rate. of current interest of the FD. That said, FRTDs could be a bit complex as a product for investors to understand. While FRTDs may offer you a higher return when rates rise, they may offer a lower return when the interest rate trend is negative.
You can invest in DFs using the laddering technique when rates are expected to rise in the near future. It can help you average the interest rate in the near future and lower the opportunity costs when the interest rate rises. FDs are easier to understand than FRTDs. If you understand the trend in interest rates, you may want to consider investing in FRTDs, otherwise stick to regular FD products.
Adhil Shetty is a guest contributor. The opinions expressed are personal.