5 things to know about fixed deposits

With interest rates rising over the last one year, fixed deposits have become popular again.

But there are certain things that you should know about fixed deposits before they go around investing in them. Here are five must-knows about fixed deposits:

1. Interest paid either monthly or quarterly

The interest on a fixed deposit is usually paid out either monthly or quarterly depending on the option that the investor chooses. So an individual investing Rs 1.5 lakh (Rs 150,000) in a one-year fixed deposit paying an interest of 8% per annum will get Rs 1,000 per month (8% of Rs 1.5 lakh divided by 12; or Rs 3,000 per quarter (8% of Rs 1.5 lakh divided by 4).

Other than this, those depositing money in a fixed deposit also have the reinvestment of interest option available.

2. The yield or return on a fixed deposit is different from interest.

An interest of 8% in a year would mean a return of 8.24% in a year for those individuals who opt for the reinvestment of interest option.

What this means is that Rs 100 invested at the beginning of the year will amount to Rs 108.24 by the end of the year. This is because the interest earned is compounded every quarter.

An interest of 8% in a year would imply an interest of 2% in a quarter. Hence Rs 100 invested by an individual would earn an interest of Rs 2 (2% of Rs 100) at the end of three months. So the Rs 100 investment made by an individual would have amounted to Rs 102 by the end of three months (Rs 100 + 2% of Rs 100). Since this interest is reinvested, the individual earns 2% interest on Rs 102 for the next three months. The interest earned for the next three months is Rs 2.04. This interest is also reinvested and the individual earns an interest of 2% on Rs 104.04 for the next three months.

Repeating this process at the end of the year, the individual has accumulated Rs 108.24 and hence a return of 8.24%, which is higher than the interest of 8%.Given this individuals putting money in a fixed deposit who do not need a regular income from the fixed deposit, it makes more sense for them to opt for the reinvestment of interest option and earn a greater return.

3. Want to break a fixed deposit? Careful

At times it might become necessary to break the fixed deposit either because the money is immediately required or for the fact that other banks have started offering a higher rate of interest on the deposit.

Breaking a fixed deposit has a cost attached to it. Most banks, on premature withdrawal, give an interest which is 0.5% lower than the interest applicable for the period for which the deposit has remained with the bank.

Let's try and understand this through an example. An individual makes a three-year deposit, paying an interest of 9% per annum. Due to urgent need of money he may have to break the deposit at the end of one year. The bank for a period of one year pays an interest of 8.5%. The individual will be paid an interest of 0.5% less than 8.5% which is 8%.

4. The interest earned on a fixed deposit is not tax free

The interest earned from a fixed deposit gets added on to the income for the given year and is taxed according to the tax bracket that an individual falls into. Hence, for those falling in the top tax bracket the interest earned from a fixed deposit is taxed at the rate of 33.99%.

5. It is possible to take loans against fixed deposits

This works out to be cheaper and involves less paper work vis a vis taking a personal loan.

By -- Chandnee Sinha