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A fixed deposit is one such financial instrument which will help you deposit a sum with a bank for a predetermined period of time and the bank pays an interest on that sum. In essence, it’s a way of lending money to a bank, the opposite of taking a loan. These are sometimes even referred to as bonds or term deposits.
A fixed deposit is one of the primary sources of cheap capital for any bank. This capital, multiplied by millions of fixed deposits made by a countless number of people adds up to a huge corpus which the bank lends out to people in the form of various loans, among other investment avenues. The difference in the interest received by the person making a fixed deposit and the interest received by the bank from a person paying back a loan is where the bank makes its money.
How Fixed deposit works for banks
For instance, if person “A” makes a deposit of Rs.10,000 with the bank for 2 years, he receives an interest of 7% pa (compounded yearly) from the bank. Now the bank has a sum of Rs.10,000 with itself for 2 years. Let us say person “B” requests a loan of Rs.10,000 from the same bank. The bank will now lend out the sum of Rs.10,000 it holds to person “B”, charging an interest of 12% pa (compounded yearly). At the end of 2 years, person B pays back the principal of Rs.10,000 along with the interest of Rs.2,544 but the bank has to also pay back person A its principle amount and the interest paid by the bank is just Rs.1,449. So the difference of 2544-1449=1095 is what the bank profits. If understanding this concept, then you know how any modern day bank works.
The rates of interest offered by the banks for a fixed deposit is mainly decided by the RBI in India. This decision of what the interest rates offered must be, is arrived after lengthy and complicated calculations and an elaborate decision-making process.
Features of a Fixed Deposit:
The Principal Amount
Needless to say this (but I still have to) you will receive the WHOLE principle amount back at maturity. This principle amount is what you keep with the bank as a deposit and what earns you interest. The interest rate is applied to this principle amount to find the amount of interest payable to you by the bank.
Maturity
Maturity is the tenure or the period for which the fixed deposit is made. For instance, in the above example, the maturity of the fixed deposit made by “A” was 2 years. The minimum period one can opt for a fixed deposit is 7 days and this period can go up to 10 years.
Maturity Amount
The amount received by you at the end of the maturity is called the maturity amount. This maturity amount comprises of the principle amount in addition to the interest earned on the fixed deposit. Banks now a days also have an auto-renewal system with the help of which after confirming with you, the deposit is rolled over for a new tenure.
Interest rate
As mentioned above, the interest rates (also called “repo rates”) are mainly decided by the RBI which keep updating them time and again. There are a lot of factors over which the RBI decided what the rates of interest should be. Individual banks offer their rates of interest very close to this rate decided by the RBI.
Also, interest rates for senior citizens are always substantially higher.
Liquidity
Fixed deposits are considered to be illiquid assets. Yes if you need to, you CAN withdraw your money before maturity but your bank might charge you a penalty for withdrawal before the maturity. The exit criteria from a fixed deposit of every bank are subject to their individual policies and hence we suggest you should be well aware of these criteria before opening a deposit.
Interest:
The main reason why you should opt for a fixed deposit is because these deposits offer far better returns in the form of interest than a normal savings account. There are various ways how you can choose to receive the interest earned on your deposits. We shall discuss this in detail when I explain different types of fixed deposits ahead.
Risk:
Since the deposit is a way of lending money to the bank, the risk is virtually zero. The only way your bank won’t be able to pay you back the money promised to you at maturity is if the bank shuts down, and what are the chances of that happening. Fixed deposits are considered as the safest form of investments.
Tax Treatment:
If you are a salaried employee, you will know about TDS (Tax Deducted at Source). For the ones of you not well versed with this tax; if your interest receivable at the end of a financial year from your fixed deposit exceeds Rs.10,000, the bank will deduct the TDS and provide a receipt to the deposit holder as a TDS tax receipt. The tax on the interest is applicable at the rate of the tax slab that the deposit holder belongs to. Hence if the deposit holders overall income is less than 2.5lpa then there are no tax deductibles. The government of India does not allow proceeds of a fixed deposit to be paid in cash if the said proceeds are in the excess of Rs.20,000 in any year.
Types of FDs:
Simple FD:
These have two different types of pay out methods. The quarterly payouts or regular payouts earn a simple interest on the amount of money put into the deposit. This interest will be paid to you in the regular installments throughout the time period and at maturity, the principle is paid back. The second kind of payout method is the typical one where the interest every year is added to the principle for the next year. This is compound interest and will be paid to you at maturity.
Flexi-Fixed Deposit/ Sweep FD:
The Flexi deposit is linked to a savings bank account. A number of funds in the deposit can be swept in and swept out to the savings account it is linked to. For example: If you have Rs.20,000 in your Flexi FD and your savings account has only Rs.5,000, you can withdraw more than what your savings account contains. The additional money will be deducted from your Flexi deposit directly.
Tax Saver FD:
With this type of fixed deposit, you can enjoy a deduction of up to 1.5 lakh pa under section 80c. The tenure of this deposit is 5years and the deposit cannot be broken at all.
One cannot request a loan against this kind of FD.
One additional advantage of opening an FD is that you can avail a loan from a bank against your FDs (except a tax saver FD). Although these rates of interest may or may not be able to beat inflation, it is better to earn 7%-8% interest than to earn almost nil keeping your funds in a savings account and see it loose its value 6% pa(due to inflation). To see why investing in a fixed deposit is not a goo idea . Read my post on https://blog.bodhik.com/5-reasons-you-should-not-invest-in-fixed-deposits
FAQs
Who and how can someone apply for an FD?
Any individual or institution can apply for a fixed deposit at any bank. The individual or institution just needs to have a savings account in that bank.
2. Why is a fixed deposit beneficial?
A fixed deposit although has lesser liquidity than a savings or current account, it provides higher returns for your money. The rates of interest on fixed deposits are more than that of any account.
3. What is the minimum amount to make a fixed deposit?
Starting from Rs.1,000 you can make a fixed deposit of any amount.
4. Can I withdraw money from my FD before it reaches maturity?
Yes, you can very easily withdraw your money or “break” the deposit before maturity. You will receive 0.5-1% lower interest than what you were promised by the bank as a penalty for premature withdrawal.
5. Are the interest rates equal for everyone?
No, Senior citizens receive higher interest.
How and where will the tax be deducted?
The tax will be deducted from your interest yield if it exceeds Rs.10,000. The rate of interest will be decided by which tax slab you belong. Which means the interest earned by your FD will be treated as income as an individual to you.