The interest rates have risen in the past few months. Should you be breaking your old FDs and opening new FDs with higher rates? Is there any penalty involved? What should you do? Read on.
The interest rates have increased very rapidly in the last few months. A one year bank fixed deposit (FD) that were fetching 7.00-7.50% is now fetching 8.50-9.00%.
So what should you be doing? Is there any advantage in breaking your old fixed deposit prematurely, and keeping the money in a new FD paying a higher interest rate? And is there any disadvantage in doing so?
(For more details on bank fixed deposits, please read “Fixed Deposit (FD) – A favourite for generations” and “Fixed Deposits (FD) for saving income tax through section 80C”)
Let’s weigh the pros and cons, and find out what you should be doing.
What is “breaking” a fixed deposit (FD)?
Breaking an FD means pre-mature withdrawal of your money locked into an FD – you break an FD when you take out the money before the term of the FD is over.
Charges involved in breaking an FD
Rate of interest applicable
The first penalty is in the form of a reduced interest rate for you.
When you break an FD, banks don’t give the rate of interest at which you kept the FD – you get the rate applicable for the duration for which you actually kept the money with the bank.
Confusing? Let’s understand this through an example.
Let’s say you kept an FD for 4 years, with an interest rate of 8%. Now, you want to break it after 2 years. In this case, what interest rate would you get?
You would get the rate applicable to a 2 year FD prevailing at the time when you had kept your FD, and not the interest rate of 8% which was applicable to a 4 year FD.
So, if the rate for 2 years FD was 7.25% when you had kept your 4 year FD, you would only get an interest of 7.25% per year for the 2 years you have kept the money with the bank – and not 8% per annum.
Penalty in rate of interest
But it doesn’t stop at that – most banks also charge a penalty in interest rate, which is 0.5% to 1%.
When you break an FD, banks normally give you interest that is lower by 0.5%-1% than the interest we saw above (the interest for an FD of the duration for which you have kept the money with the bank).
Let’s continue our example to understand this better.
If the rate for 2 years FD was 7.25% when you had kept your 4 year FD, and if the penalty is 1%, you would actually get an interest of 6.25% per year for the 2 years you have kept the money with the bank (and not 7.25% or 8%).
Waiver of interest rate penalty
Some banks do waive off this penalty if the liquidation or premature withdrawal of the FD is due to some emergency. But the definition of “emergency” is not well defined, and this waiver is given on a case-to-case basis.
Some banks also waive off the penalty if you reinvest the withdrawn amount with the bank. Some banks provide this waive off only if the new FD is kept for a period higher than the remaining period of the original FD.
Example
Let’s calculate the payout from the FD in both the cases:
- Holding the original FD till maturity, and
- Breaking the FD and reinvesting at a higher rate
Holding the original FD till maturity
FD amount:1 Lakh
Rate of interest: 8%
Period of FD: 4 years
Interest received:32,000
Breaking the FD and reinvesting at a higher rate
FD amount:1 Lakh
Rate of interest: 8%
Original period of FD: 4 years
Actual period of holding: 2 years
Rate applicable for 2 years: 7.25%
Penalty: 1%
Actual rate applicable: 6.25%
Interest received for 2 years:12,500
New FD duration: 2 years
New FD rate of interest: 9%
Interest received for these 2 years:18,000
Total interest received:12,500 +18,000 =30,500
Conclusion
In our example, you are actually at a loss of1,500 when you break an FD and reinvest it at a higher rate!
So, tread carefully while you are breaking your FD!
When does breaking an FD make sense?
Breaking the FD and reinvesting the sum in a higher-interest nearing FD is positive for you only when the original FD is relatively newer – in this case, the penalty doesn’t hit you that much.
If the original FD is old or nearing maturity, it is best to continue with it and reinvest the money only when it matures.
Example of breaking a newer FD
Let’s calculate the payout from the FD in both the cases when the old FD is relatively new:
Holding the original FD till maturity
FD amount:1 Lakh
Rate of interest: 8%
Period of FD: 4 years
Interest received:32,000
Breaking the FD and reinvesting at a higher rate
FD amount:1 Lakh
Rate of interest: 8%
Original period of FD: 4 years
Actual period of holding: 6 months
Rate applicable for 6 months: 6.5%
Penalty: 1%
Actual rate applicable: 5.5%
Interest received for 6 months:2,750
New FD duration: 3.5 years
New FD rate of interest: 9%
Interest received for these 3.5 years:31,500
Total interest received:2,750 +31,500 =34,250
Conclusion
In our example, you are at a profit of2,250 when you break a relatively new FD and reinvest it at a higher rate!
So, break an FD only if it is relatively new, and only after you do your calculations!
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