Is It A Right Time To Break FD?

Sumit has a Fixed Deposit (FD) with SBI bank and is very upbeat about the high interest rate scenario at present. He is contemplating to break his FD and re-invest the amount at higher rate. His hypothesis lies with a general perception of sustained inflation keeping up the interest rates high in the near future. However, he is perplexed to go ahead with its plans.

Sumit is neither alone nor the only optimistic person about the high interest rates at present. He is also correct to a certain extent However, he must realize that interest rates are a result of inflation alone but includes overall liquidity position of individual banks. Here, the liquidity position has improved over the past few months, in banking system, on account of lean credit growth and enough deposit growth (on the back of previous hikes in interest rates) to reduce asset-liability mismatch for banks.

Banking Sector: Deposit-Credit Growth

Besides, government has infused significant money into PSU banks during the Jan-March quarter to help them maintain 8 per cent tier-I capital by March 31, 2011.  This is in addition to an additional capital infusion of Rs 6,000 crore in 10 public sector banks with an objective to raise its holding to minimum 58 per cent in all state-run banks. The ongoing capital infusion is to enhance lending capacity of respective banks to cater to the growing credit demand and maintain economic growth momentum.

For apparent improvement in liquidity position, many are predicting interest rates to head southwards now. In fact, we have already seen signs of interest rates softening by few banks including Central Bank of India & Oriental Bank of Commerce across various maturities. This was for the first time in 6 months that banks had cut deposit rates. Others are expected to follow suit depending upon their individual asset-liability position.

Post RBI’ credit policy, liquidity position also draws inference from 1) FII investments: affecting market liquidity as a whole, 2) Inflation which is expected to cool down given robust Rabi crop hit the markets in June 3) Lower Credit Demand as first half generally yield lower credit demand and 4) Government borrowing which also expecting to be lower providing ample scope for interest rates softening.

Therefore, although theoretically correct, Sumit’s general perception proves wrong in current prevailing scenario wherein despite high inflation and subsequently interest rates hike by RBI, interest rates on FDs are poised to decline (though cannot be standardized in coming months depending upon improved liquidity position, lower credit demand etc.) For Sumit, it’s not an ideal time to pull out from his existing FD.

Even if Sumit has to do it, he must do it now, before the decline gain momentum. Also re-investing has to be a very calculated step, as factors such as duration of your existing FD, tenure remaining, pre-payment charges, etc., must be considered. These factors alone can impact considerably on the profitability for your investment..  Let’s see a realistic example…

Let’s assume Sumit had FD worth Rs 1, 00,000 with 2 scenarios listed below:

It is worth noting that when you break a FD, the interest you will earn is equal to the rate applicable for the duration for which you’re your FD was held. In our example, Sumit break the FD after 609 & 137 days respectively, so he will earn interest rate for similar duration FD applicable when they were created, i.e., 15^th June, 2009 and 1^st Oct’10 respectively.  The deposit rates offered by SBI on the said dates were 7.0% and 5.5% respectively. The effective rate of interest gets reduced by 1% after factoring in pre-closure charges.

In case of withdrawal, Sumit gets Rs 1,02,002 and Rs 1,01,689 respectively under both situations, which is assumed to be re-invested in FD for a tenure equal to remaining duration of original FD and earns interest at higher prevailing rates. If we compare the combined proceed of two FDs with what the original FDs would have fetched, we find that scenario I is highly unattractive, resulting in gross loss of Rs 35,953. However, Scenario II is positive and worth a try.  So both situations yield contrasting results.

The bottom line is to do your math before you proceed.