- How do banks operate?
- How fixed deposit interest rates fluctuate
- What does an increase or decrease in fixed deposit rates mean?
- Points to keep in mind while investing in fixed deposits
Fixed Deposits have always remained a secure source of investment for risk-averse investors. They offer higher interest rates than savings bank accounts and are more secure compared to investments like the stock market, gold, jewellery and real estate.
Therefore, it's a preferred choice for people looking forward to reducing their portfolio risk. However, even though fixed deposits are fixed income instruments, banks change interest rates on FD schemes time and again.
This is because fixed deposits interest rates are influenced by various macro-economic factors and policies adopted and implemented by the RBI to counter the adverse effects of external factors. Let’s understand the banking mechanism before we examine these factors closely.
It is well-known that banks take deposits from their depositors and lend them to their borrowers. These depositors can be savings bank account holders, current account holders, fixed deposit holders or any other depositor that puts his money into the bank.
Other than depositors, banks also borrow from the RBI. The interest rate charged by the RBI for the same is known as the Repo Rate. Vice versa, banks also lend money to the RBI at an interest rate known as the reverse repo rate. This is how the RBI controls the economy through bank lending.
A change in repo rate or reverse repo rate can change spending and consumption patterns. Let’s understand how these factors can impact interest rates
Various factors play a key role in changing a fixed deposit's
Demand and supply: This is influenced by consumer spending habits. If consumers are borrowing less, it means that there is less demand in the market. As the banks primarily earn from lending, if the borrowers reduce, then the banks resort to reducing the interest rate that they pay to their depositors such as fixed deposit interest rates. However, if the demand for credit is more, then the banks may increase the interest rates on the deposits that they collect from people to attract more depositors and increase their funds to lend.
Inflation: If there is high inflation in the economy, then the RBI will take measures to reduce the same. Usually, inflation increases when there is more demand in the economy than the supply, leading to an increase in prices.
Therefore, to control the demand, RBI will increase the repo rates, thereby making it costly for the banks to borrow from them. Banks will resort to borrowing from the public by increasing the interest rates on deposits. This will encourage savings among the public, getting them to spend less and invest more. The result is a drop in demand, which will lead to a reduction in the inflation rate.
CRR and SLR: Cash Reserve Ratio (CRR) is the amount of funds that the banks are required to keep with the RBI. Statutory Liquid Ratio (SLR) is the amount of funds that the banks have to maintain with themselves in the form of gold, liquid cash and other liquid securities.
If the bank hikes the CRR, then they will have to keep more deposits with the RBI, and will be left with fewer funds to lend to the borrowers. Therefore, they will ask the public to make more deposits in the bank in the form of savings accounts, fixed deposits, etc. It is not necessary that the banks will increase fixed deposit or savings account interest rates, however, the bank may resort to this to increase public deposits into their accounts. The same applies to SLR as well.
Liquidity: Liquidity refers to the availability of funds in the economy, and especially banks. If the banks have adequate liquidity, then they won't require funds from the public to lend to the borrowers. Therefore, they won't change the interest rates on deposits. It can sometimes lead to a reduction in interest on deposits like FD schemes. However, if the banks are facing a liquidity crisis, they may increase the interest rates on deposits to attract funds to continue their lending activity.
If there is an increasing trend in the fixed deposit interest rates, then it means that the RBI is encouraging savings among the public and discouraging spending. Also, the borrowings may become costlier as the bank may charge more interest to meet its cost of funds. Alternatively, if the interest rates are falling, then it means that steps are being taken to encourage the public to spend more on goods, commodities and services. Borrowings will get cheaper, allowing people to take more to spend. This in turn channelizes the rotation of money in the economy.
If you are a risk-averse investor and want your investments to be almost risk-free, you can consider investing in fixed deposits. They will provide interest greater than a savings bank account, but will only cover inflation. However, if you fall in the senior citizen category, then you will earn more interest in fixed deposits than the normal rates.
This is because banks usually provide senior citizens 0.5%-1% more interest than normal depositors. As senior citizens are at a later stage of their lives, they seek risk-free investments since they don't have as much of a risk appetite as a younger person has.
The amount of interest earned gets accumulated in fixed deposits, which is then compounded to increase the value. The principal along with interest is paid at maturity, and is therefore known as a cumulative fixed deposit. In the case of non-cumulative fixed deposits, the interest is not accumulated but is instead paid out to the depositor as an income.
Also, the liquidity of fixed deposits depends on the term for which deposits have been made. The amount gets locked in for the tenure of the deposit, and if withdrawn prematurely (i.e., before maturity), then penal charges will be levied by the bank. Therefore, if you have excess money, and you are seeking to invest in fixed deposits, then you should break the amount and then deposit. For example, if you want to invest Rs. 3,00,000 into fixed deposits, then invest Rs. 50,000 - Rs. 60,000 per fixed deposit and create 5-6 such deposits. Then, in case of any emergency, you won't have to break all the fixed deposits at once.
Fixed deposits also offer tax benefits under Section 80C of the Income Tax Act, 1961, provided that the amount invested is locked in for 5 years. The amount invested in such fixed deposits will be deducted from the income of the depositor up to the value of Rs. 1,50,000. However, it is pertinent to note that the interest earned on such deposits would still be taxable.
If you are looking to invest in FD schemes, check Shriram City Fixed Deposits for attractive interest rates. Use Shriram City Fixed Deposit Calculator to find out your savings and maturity value.