The recent 50 bps rate cut by the US Federal Reserve has raised expectations for similar or at least a shallower rate action from the RBI. While the repo rate cuts should reduce the borrowing cost for fresh and existing borrowers, especially those having loans linked to the repo rate, fixed deposits opened post-rate cut are, more likely than not, to offer lower yields. As many banks are still offering attractive rates on their FDs, depositors having surpluses may decide to book FDs, preferably for longer tenures, for earning higher real interest income post-reversal of the interest rate regime.

Here I will discuss some FD factors and benefits to help FD depositors make optimal decisions.

Fixed Deposits opened with high-yield offering banks are also covered under deposit insurance

Deposits of up to Rs 5 lakh opened by each depositor with each scheduled bank are covered under the deposit insurance program of the Deposit Insurance and Credit Guarantee Corporation (DICGC), a subsidiary of RBI. This insurance program covers fixed deposits as well as the deposits maintained in savings accounts, recurring deposits and current accounts. The primary aim of this insurance program is to provide a measure of protection to the depositors from the risk of losing their savings due to bank failures. Both the interest and principal component of the qualifying deposits are insured under this program.

Currently, most small finance banks are offering 100-150 bps higher interest rates than PSU banks and major private sector banks. Banks like Suryoday Bank and Unity Bank are offering FD rates in excess of 8% p.a. on tenures of 5 years and above. As the Rs 5 lakh insurance cover applies separately to deposits maintained with each scheduled bank, risk-averse investors can increase their effective insurance cover by distributing their FDs across multiple small finance banks.

Ignoring liquidity requirements and investment horizons can cost you penal rates Many depositors select their FD tenures solely on the basis of the interest rate offered, ignoring important factors like liquidity requirements and investment horizons. Thus, unforeseen financial emergencies or over-looked financial goals might lead such depositors to close their FDs before their maturity dates. Note that most banks charge premature withdrawal penalties of up to 1% on premature or partial withdrawals. This penal rate is deducted from the effective rate of interest of an FD, which is usually the lower of the contracted FD rate and the FD interest rate for the period for which the FD remained open. Thus, depositors should factor in their liquidity requirements and investment horizon of their financial goals to reduce the risk of incurring premature withdrawal penalty.

Tax-saving FDs do not generate tax free income

Section 80C of the IT Act allows tax deduction of up to Rs 1.5 lakh per financial year on investments made in tax saving FDs. These tax saving FDs have a lock-in period of 5 years. However, just like other FDs, the interest income earned from tax-saving FDs are also taxed as per the tax slab of the depositor. Only the interest income earned by senior citizens from their tax saving FDs is eligible for tax deduction under Section 80TTB. This section allows a tax deduction of up to Rs 50,000 to senior citizens on the interest income earned from various deposits (including FDs) maintained with banks and post office.

As the post-tax returns from tax-saving FDs usually fail to beat inflation rates, especially for those in the higher tax slabs, risk averse investors seeking inflation-beating returns can instead consider small savings schemes like PPF, NSC and Sukanya Samriddhi Yojana, which offer Section 80C benefits as well as tax free returns. Those with higher risk appetite can opt for Equity Linked Saving Schemes (ELSS) to earn higher post-tax inflation adjusted returns. These funds have a lock-in period of just 3 years, one of the shortest lock-in periods offered by investment instruments eligible for tax deduction.

Leveraging your FDs to improve your credit score and manage cash flow mismatches

Many banks allow their depositors to leverage their fixed deposits through secured credit cards and overdraft facilities. Loan against fixed deposits is offered in the form of overdraft facility, which makes it an excellent tool for mitigating frequent cash flow mismatches. Banks charge interest only on the amount drawn from the overdraft limit till their repayments and the depositors continue to earn interest on the pledged FDs during the loan tenure. Secured credit cards offer an additional utility to individuals unable to avail regular credit cards due to credit score or other eligibility factors. Secured credit cards can also help individuals steadily help build/improve their credit score as the banks report the secured card transactions to the credit bureaus. Thus, disciplined usage of secured credit cards can help their cardholders steadily build or improve their credit scores. Just like loan against FDs, depositors availing secured cards continue to accrue the interest income from the pledged FDs.

Your tax liability would not end with TDS

The income tax liability of FD investors does not end with the TDS deduction by the banks. While the TDS is deducted at the rate of 10% (20% for depositors who have not provided PAN), the interest income earned from FDs is taxed as per the tax slab of the depositor. Moreover, no TDS is deducted by the bank if the total FD interest income credited by the bank in each financial year is less than Rs 40,000. The difference between the total TDS deductions and your actual tax liability on your FD interest income is adjusted at the time of filing income tax returns. Thus, depositors should always factor in their tax slabs while calculating their post-tax returns from their FDs. This will help them in making a more holistic comparison between fixed deposits and other fixed income instruments like debt mutual funds, bonds, etc.

Conclusion:

The reversal of the high interest rate regime seems to be imminent, at least in the next few months. However, depositors should not ignore their liquidity requirements and investment horizon of their short-term financial goals in their pursuit of choosing tenures offering the highest FD slab rates. They can also spread their FDs across small finance banks offering high-yield FDs to earn higher risk-adjusted returns. Individuals can also leverage their FDs, if allowed by their banks, to deal with their frequent cash flow mismatches and/or for building/improving their credit scores.

(Gaurav Aggarwal, Chief Business Officer, Unsecured Lending, Paisabazaar)