How The Tenure Of Your FD Affects Its Interest Rates

Fixed Deposits (FDs) are one of the most popular forms of savings due to their reliability and risk-free nature. For a risk-averse investor, the importance of an FD as part of their portfolio is always paramount. The trust of Indian investors in fixed deposits is depicted by a Statista report, which suggested that the total value of FDs in Indian banks was INR 46.82 trillion in 2020¹. 

As an investment tool, FDs can be used for retirement planning and other financial goals. It is worth noting that the FD returns depend on various factors, including tenure, bank policies, and economic conditions. But have you ever wondered how choosing a tenure can impact the returns on your FD? Does a longer tenure always result in higher interest rates or returns?

You might be surprised to learn about the impact of tenure on FD returns and how you can use it as an effective investment tool. Let’s begin with considering a few pros and cons of fixed deposits.

Advantages of Fixed Deposits

Here are the most critical advantages offered by a fixed deposit:

1. Highly Secure and Low Risk: FDs are generally unaffected by market volatility as the principal amount is protected and you get a guaranteed return.
2. Fixed Returns and Compounding Benefits: Once you have a fixed deposit in a bank, the interest rate does not change throughout the predetermined period. 
3. Liquidity Options: There are options of withdrawing FD (completely or partially) for meeting financial emergencies. 

Disadvantage of Fixed Deposits

Here are a few disadvantages of Fixed Deposits:

1. Lower Returns Compared to Equity-Based Investments: Fixed Deposits offer a fixed rate of return (which is currently up to 7.5-9.5%) often lower than average equity-based instruments’ returns. 
2. Taxability of Interest Income: Any interest earned on FDs is subjected to income tax as per your relevant slab rate. 
3. Inflation Risk: If the inflation is higher than FD returns, the overall financial planning can be affected as the investment's real value reduces over the deposit's tenure. 

Factors Affecting Fixed Deposit Interest Rates

Here are the most critical factors that impact FD interest rates:

1. Economic Conditions and RBI Regulations: When inflation rises, banks may increase FD rates to attract deposits. Similarly, increasing the repo rate often leads banks to offer higher FD rates to maintain deposit growth.
2. Bank Policies: There can be a difference between interest rates offered by public and private sector banks based on tenure and category of investors. 
3. Type of Fixed Deposit: If an investor opts for cumulative FD (where interest accumulates and is paid at the end of the period), there is a chance of earning a higher return compared with the traditional alternatives. 
4. Market Competition: Banks and financial institutions can offer schemes, attractive rates, packages, etc., to remain competitive. 

Impact Of Tenure On The Interest Rate

You must be aware of the impact of tenure on the interest rates and overall returns offered by fixed deposits. Typically, when the investment is for a longer period, the compounding effect kicks in, thereby offering a higher return to the investor. 

Longer tenures usually offer higher rates because banks look forward to incentivizing longer commitments. However, there are quite a few exceptions to this general understanding.

Hence, you should have a clear understanding of your financial goals and accordingly choose the tenure. 

Categories Of Fixed Deposits

Each category of FD has two types:

1. Non-Cumulative Fixed Deposit: Simple interest on the principal amount is paid. This interest can be transferred to the savings account and may be used for any purpose. For investors looking to generate a regular income stream from an FD, this can be a good option. 
2. Cumulative Fixed Deposit: Compound interest on the principal amount as well as accumulated interest at the end of each compounding period is available. You get compounding benefits as the effective ROI is higher than the previous option. This alternative is perfect for long-term goals and financial plans. 

Does A Longer Tenure Always Mean Higher Returns?

Contrary to popular belief, a longer tenure might not automatically result in higher returns. There are circumstances such as the existing economic conditions, promotional offers, and liquidity requirements (of banks) based on which even short-term FDs can provide higher returns. 

Example: Akshat is an Apple fanboy and currently owns an iPhone 13 Pro Max. He bought it two years ago and wishes to get the new one after two years. He currently has INR 1 lakh set aside for the purchase. He came across two FD options: for one year with ROI 9.5% (Diwali Offer) and for two-years with ROI 8.25% (regular offer). Here is what he will have at the end of the two-year period:

What Tenure Of Deposit Should You Opt For?

Having a longer tenure can typically lead to higher returns in the long-term but it is not a rule of thumb. There are numerous exceptions to this, as suggested by the previous example. Consequently, you should consider your personal financial position and goals before zeroing on a tenure. 

You must also carefully analyse the impact of interest rates offered by different banks and its effect on your financial goals. Currently, ROI on FDs can go up to as high as 7.5-9.40% (depending on FD category and banks). If you are looking towards retirement planning or any other long-term financial goal, you must try to avail an FD with as high ROI as possible to lock-in the high FD rates. 

Example (Cont.): Getting back to Akshat, who is now contemplating retirement planning. He plans on retiring after 15 years. He currently has a corpus of INR 10 Lakhs. He has a couple of offers (for a 15-year tenure) but the interest rates range between 7.00-7.50% per annum. 

On the other hand, he has one option that pays 9.25% per annum but only for 5 years. He expects ROI to reduce at least 50 basis points after 5 years and another 100 basis points after the next five.

It is clear that with a slight increase in ROI, there is a significant increase in total percentage of interest earned, especially in longer tenures.  

If you have a strategic, long-term goal, you can choose a longer tenure to maximise returns through higher rates and compounding. It is always good to use an FD calculator to evaluate and compare different tenures and corresponding returns. 

Conclusion

Fixed Deposit tenure is critical for determining the applicable interest rates and overall return on investment. Typically, longer tenures mean higher returns, but you must be aware of other factors, such as economic conditions and bank’s offerings which may result in higher interest rates, even in short-terms.  

As a risk-averse investor, FDs can be an excellent option, helping you attain personal financial goals without being exposed to market volatility. It is also quite useful as a diversification tool.

Frequently Asked Questions On Tenure Of Fixed Deposits

1. Does FD interest rate change after maturity?

No, once an FD matures, the interest rate does not change; however, if it is renewed, the new interest rate will depend on prevailing rates at the time of renewal.

2. Which tenure is best for FD?

The best FD tenure depends on individual financial goals, with short-term tenures suited for liquidity and long-term tenures offering potentially higher returns. 

3. Is it advisable to close FD before maturity?

Closing an FD before maturity is generally discouraged as it often incurs a penalty and reduces the effective interest earned. 

4. How to calculate FD Returns?

FD returns can be calculated using the formula A = P(1 + r/n)^(nt), where A is the maturity amount, P is the principal, r is the annual interest rate, n is the compounding frequency, and t is the tenure in years.

 References

1. Statista, Accessed from https://bit.ly/3OfbkH8.

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