Look at the fixed deposit (FD) interest rates offered by banks and many fintech organisations, and you will find so many small finance banks (SFBs) scoring above the rest. For example, Unity Small Finance Bank leads with the most attractive FD interest rate at nine percent per annum, followed by Shivalik Small Finance Bank offering rates at 8.65 percent per annum. Within scheduled private sector banks, SBM Bank stands out with the highest FD interest rates, reaching up to 8.25 percent. Many public sector and private banks are also offering more than seven percent interest, thus, prompting many risk-averse investors to put most of their earnings in these traditional investments at one go.
Risk-averse investors look upon FDs as a preferred option, seeking guaranteed returns and a relatively low-risk investment. However, an associated drawback is the mandatory lock-in period, and early withdrawal incurs a penalty. The penalty amount varies among banks but typically ranges from 0.5 percent to one percent of the principal amount.
In addition to the penalty, withdrawing funds prematurely results in a forfeiture of interest on the withdrawn amount. This is due to the compounding nature of FD interest, where you earn interest on your already accrued interest. Early withdrawal disrupts the continuous accumulation of interest on both the principal amount and the interest previously earned on that sum.
Adopting a laddering strategy
Astute investors employ a laddering strategy when investing in FDs. This involves dividing the funds into smaller amounts and distributing them across FDs with varying tenures. By doing so, they steer clear of locking up all their capital in a single FD, simultaneously capitalising on the higher interest rates offered by FDs with longer tenures.
The following example illustrates how one can implement a laddering strategy for FDs. Suppose you have ₹200,000 for investment. While putting all the funds into a five-year FD would lock your money for the entire duration, adopting a laddering strategy offers an alternative approach. Distribute the investment across FDs with different tenures, for instance,
- ₹50,000 in a 1-year FD
- ₹50,000 in a 2-year FD
- ₹50,000 in a 3-year FD
- ₹50,000 in a 4-year FD
This way, you gain access to ₹50,000 annually, and you can also capitalise on the higher interest rates associated with longer-term FDs.
Why invest in a staggered manner?
Implementing a laddering strategy with FDs can enhance interest returns and mitigate liquidity challenges. Here are a few reasons why:
- Adaptability: Employing a laddering strategy with FDs provides flexibility in your investment approach. You can modify the durations and amounts of your FDs to align with changes in your financial requirements.
- Enhanced interest: FDs with longer tenures typically yield higher interest compared to those with shorter durations. Laddering FDs enables you to capitalise on these elevated interest rates, maximising your investment returns.
- Reduced liquidity shortfall: With multiple FDs maturing at different intervals, you maintain continual access to a portion of your funds. This reduces the likelihood of needing to prematurely break an FD and incurring penalties.
- Mitigated loss in early withdrawal: In the event of an early FD withdrawal, the impact on your interest loss is minimised compared to investing all funds in a single FD. The loss is confined to the specific FD being broken, while the remaining FDs in your ladder continue to accrue interest.
It has been observed that many investors break into their long-term FDs to get rid of their loans or prepay their debt. This not only puts a break into the yields received from the FDs but also causes a loss from the penalty due to premature withdrawal.
Laddering FDs offers investors the distinct advantage of consistent access to their funds due to the staggered maturation of different FDs. This accessibility proves valuable during unforeseen expenses or when seizing short-term investment opportunities.
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