“Debt instruments are for investors with a low-risk appetite”.
You often hear this statement from financial advisors. It is true, but not 100%. Risk-bearing capacity matters more than risk appetite. No financial advisor worth his salt will ask you to invest the entire corpus in high-risk investments.
So, debt instruments are a part of every sound financial plan. But what are debt instruments?
DEBT INSTRUMENTS
Debt instruments are financial products which yield a fixed income, and are not subject to highs and lows in stock markets.
A debt instrument is a tool an entity can use to raise capital.
Source: Wikipedia
Yes, our very own fixed deposits are tools used by banks and non-banking finance companies to raise capital for lending. Corporates raise capital to meet liquidity needs.
WHY DO WE INVEST IN DEBT INSTRUMENTS?
A thumb rule says not more than 40% of your investible assets should be in equity.
Other than this, not everyone has sufficient knowledge, risk appetite or risk-bearing capacity to invest in equity. Real estate is an illiquid investment. We do not sell gold like we use cash.
So, let’s discuss the most common debt instrument first – fixed deposits.
BANK FIXED DEPOSITS
Fixed deposits are attracting attention in a rising interest rate regime, and it makes sense to make hay while the sun shines.
A fixed deposit is called so, because the principal amount, rate of interest and period remain fixed under an implied contract. You are assured of the promised rate of return, unless you decide to break the contract for some reason.
Fixed deposits need a minimum investment of Rs.1000/- for minimum 7 days. There is no ceiling on invested amount, but the maximum period is 10 years.
Renewal options are auto-renewal, credit of proceeds to linked savings account or remit money by DD/Electronic transfer.
You may choose between re-investment products (with compounded interest), or a fixed deposit with monthly or quarterly pay-out of interest.
Compound interest is available on FDs with a tenor of more than 6 months, as interest application is quarterly.
Premature withdrawal
Can fixed deposits be withdrawn before maturity?
Yes. You can withdraw your money before the end of the term with a penalty, but partial withdrawal is not allowed. Banks apply penal interest in the range on 0.25% – 3% on premature withdrawal.
For example, you have a FD of Rs.100,000/- at 7.5% for 1 year. You need the money at the end of 7 months.
The bank will check the rate applicable to a deposit for 7 months, on the start date of the FD, let’s say it is 6%. If the penal rate is 1%, they will pay you interest at the rate of 5% (6%-1%).
Banks are free to offer products without the premature withdrawal facility, but with added benefits. Some banks may have a lock-in period for fixed deposits with a higher rate of interest.
RBI allows premature withdrawal on minor account, if the guardian gives a declaration that the amount will be used for minor’s benefit. However, it is the discretion of the bank to allow this facility.
Overdraft against fixed deposits
If you do not wish to break the FD, and lose interest on the entire amount, you can opt for an overdraft or demand loan against fixed deposits. Normally, banks give 75%-90% of the principal amount as a loan, while the rate of interest charged is 2%-2.5% above the contracted FD rate.
The overdraft is in the nature of a limit or advance, not a term loan with EMI repayment. You pay interest only on the amount utilized by you.
You can choose to repay the entire amount, close the loan and take back your fixed deposit receipt. Or the bank will deposit proceeds of the FD in your loan account to close it on maturity date, and transfer the balance to your savings account.
You need to give specific instructions for fixed deposits on auto-renewal. The bank may insist on quarterly payment of interest.
Loan against fixed deposit is not given on a minor account.
Both the above processes of premature withdrawal and loan against FD can be carried out online for singly operated accounts. In case of a joint account, some banks allow you to do so online, subject to verification by two OTPs being sent to the two account-holders.
You can refer the bank’s website or YouTube channel for detailed instructions.
ARE FIXED DEPOSITS TAXABLE?
Yes. If you earn a combined interest of Rs. 40,000/- or more in a year, you are liable to pay income tax at the rate applicable to you. The threshold is Rs.50,000/- for senior citizens.
Banks deduct TDS at 10% for interest earned on deposits in the same bank. If you do not wish TDS to be deducted, you may submit required declarations.
- Form 15H (for senior citizens)
- Form 15G (for individuals and HUFs with an income below exemption limit)
The declaration says that your income is below the basic exemption limit. Submission of PAN is compulsory.
If TDS has been deducted, but you are not an income tax payer, you need to claim refund while filing tax returns.
NOMINATION & JOINT ACCOUNTS
Please ensure nomination on your FD accounts.
All account holders need to sign for premature withdrawal, overdraft against fixed deposit, placing FD as collateral for a loan or on closure of account.
(UN)FIXED DEPOSITS
Banks offer variations of the standardized product to suit customer needs.
Flexi-deposits
A flexi-deposit is a combo of savings account and fixed deposits. It gives liquidity benefits with operational convenience, and a higher interest on unused funds. The bank transfers surplus funds from your savings account to a fixed deposit, under the Sweep-In arrangement. If funds are needed for withdrawal, the bank makes the payment by withdrawing from the linked FD, subject to certain terms and conditions. This is called Sweep-Out.
- Banks may offer either Sweep-In or Sweep-Out or both with varying nomenclature.
- All transfers from savings to FD and vice versa are in round figures only (rounded off to nearest 1000 or 5000).
- Money withdrawn from FD in less than 7 days does not earn any interest.
- Money is withdrawn going by the Last-In-First-Out (LIFO) or First-In-First-Out (FIFO) facility.
Banks can decide the minimum amount to be maintained in the savings account, and the minimum amount and period of the FDs. The tenor of all FDs will be the same. The rate of interest will be as applicable on the particular tenor on start date of FD.
Floating Rate deposits
The rate of interest on floating rate deposits is pegged to the repo rate here, as repo rate plus a markup.
You gain in times of rising interest rates, but will have to suffer a loss if the repo rate falls.
INTEREST RATES ON FIXED DEPOSITS
Interest rates on bank fixed deposits usually rise and fall with RBI repo rate.
However, it is the discretion of the bank to decide rates as per their needs. It is not necessary that rates increase with tenor. The interest rate can be lower for a longer period.
Interest rates are negotiable for high value fixed deposits.
Sites like BankBazaar and PaisaBazaar give an overview of FD rates in the market, but do check individual websites and read terms and conditions related to the product.
ARE FIXED DEPOSITS INFLATION-PROOF?
Relationship managers and sellers of market-linked products have been telling you for ages that FDs give negative returns.
Let’s have a look at the current rates of interest.
Say a bank offers 7.5% interest for a period of one year. You earn Rs.7500/- on a deposit of Rs. 100,000/- at the end of the year at simple interest, and approximately Rs. 7714/- with compounding.
(Note: The effective rate of interest in compounding is called ‘yield’. It is 7.71% in this case)
You will pay income tax in the range of Rs.375/- to Rs.2250/-, depending on the tax slab applicable to you. And this is taxable only if your total interest income exceeds Rs.40,000/-.
So, you can say an investment up to Rs.5,33,000/- in a single name, in a single financial year is devoid of taxes.
The present rate of inflation is 5.41%, and it is likely to go down further with RBI efforts.
Ultimately, the effective rate of return is a function of
- total amount invested
- rate of interest
- income tax rate applicable to you
- Inflation rate
The calculations will differ from case to case.
Funds can be invested in the name of family members not liable to income tax.
Do you choose an asset class based on tax benefits?
You can opt for Tax-Saver FDs. There is a lock-in period of five years, and it qualifies for tax deduction under Section 80C of the Indian Income Tax Act. You can invest a maximum amount of Rs. 1.5 lakhs in a year.
But claiming tax benefits may not always be the reason for investing in fixed deposits. You need funds in the bank for liquidity. It can be an important component of your emergency fund.
Compare rate of return with alternate avenues available before you arrive at a decision.
HOW DO YOU CHOOSE A BANK AND OPEN A FIXED DEPOSIT ACCOUNT?
- Check interest rates.
- Explore financial statements to see if the capital adequacy ratio of the bank is 15% or more.
- Check ICRA and CRISIL ratings.
- The bank should be subscribed to Deposit Insurance and Credit Guarantee Scheme.
You can open an account online or offline. Banks usually insist that a savings account be opened to facilitate transactions. You will need to maintain the required minimum balance in the savings account.
ARE FIXED DEPOSITS GUARANTEED?
DICGC provides insurance for deposits up to Rs. 5 lakhs in a single account-holding pattern, if the bank fails.
If A invests Rs. 30,00,000/- in her single name, insurance cover is available only for Rs. 5 lakhs.
However, she may choose to invest money in joint accounts with her family members B and C. There are many account holding patterns possible.
- A
- AB
- BA
- AC
- CA
- ABC
- BCA
- CBA
In this case, insurance cover of Rs. 500,000/- is available for each account holding pattern. So, it makes sense to spread the corpus over different account-holding patterns.
However, KYC of all account holders is mandatory, and they are liable to declare source of funds, and pay income tax as applicable.
CORPORATE FIXED DEPOSITS
These deposits offer higher rates of interest than banks, but the risk is also high.
Investors with a higher risk-bearing capacity may choose to park a certain percentage of the corpus in company deposits.
Check the ratings given by credit scoring agencies such as ICRA and CRISIL.
CREDIT RATINGS
Credit scoring agencies such as CRISIL and ICRA allocate risk-based ratings to different investment products based on certain factors. This is akin to the credit score allocated to you by CIBIL, Equifax, Highmark or Experian.
Agencies use different sets of parameters, and ratings may not be identical.
In general, fixed deposits with AAA, AA and A are considered safe. However, this is no guarantee as the Dewan Housing Finance Limited experience has shown. DHFL deposits were rated AAA, but the company filed for bankruptcy.
ARE FIXED DEPOSITS TRANSFERABLE?
No. A fixed deposit cannot be transferred to another bank or another name. It is not a negotiable instrument.
You can avail loan against fixed deposits only from the issuing bank.
Research well, invest wisely and know when to withdraw.