Dilzer Consultants - Investments and Financial Planning

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Fixed Deposits

What is a fixed deposit?

A deposit made in a bank, company or financial institution for a specific period and to receive a fixed rate of return is called a fixed deposit (FD). The ‘fixed’ in fixed deposits denotes the period of maturity or tenure. Fixed deposits, therefore, presuppose a certain length of time for which you decide to put your money in an agency. The tenure also decides the rate of interest you earn.
Tenure refers to the duration or period for which you want to invest your money. This is pre-determined, but you can renew your investment at the end of the stipulated tenure if you want to. The tenure can be as short as 15 days or as long as five years.

Interest rates for the same tenure can differ from one entity to another, and are revised from time to time depending on the interest rates in the economy. For example, the State Bank of India offers 7 per cent per annum on a one year fixed deposit, while Kotak Mahindra offers 10.5 per cent on an FD for the same period. Typically, companies offer higher interest rates than banks. Within the banking industry, private banks offer the highest returns.

You can have a fixed deposit in a bank (nationalised or private), a corporate entity (financial institutions, manufacturing companies or non–banking financial companies). As FDs are unsecured in nature (they are not backed by any security), safety should be your primary concern. Returns must be secondary (though not unimportant). Stick to agencies that have a good credit rating from CRSILl, ICRA or CARE. A credit rating indicates the safety level with regard to timely payment of interest and repayment of the principal amount.

Also be wary of entities that offer unnaturally high returns. For instance, in today’s low-interest rate regime, any agency that offers 16-17 per cent per annum should be viewed with suspicion.

Things to keep in mind when you invest in a company FD:

  • Credit rating/reputation of the group. A company’s credit rating is possibly the best way to judge its creditworthiness. However, for manufacturing company deposits, it is more useful to check the size and reputation of the company or the industrial group it belongs to.
  • Interest rate. Within the same safety level (or rating), a higher interest rate is a better option. The difference in some cases can be as high as 1 percentage point.
  • Diversify your FDs. The portfolio principle applies to company deposits as well. It is always better to spread deposits over different companies and industries so as to reduce risk.
  • Period of deposit. The ideal period for which you should invest in a company deposit is six months to one year as it gives you liquidity. It also gives you the opportunity to review the company’s performance, and decide if you want to keep your money.

Types of Fixed Deposits

You can choose the frequency of interest payment on your fixed deposit. Depending on your requirement, you could opt for a monthly, quarterly or annual option. You can also choose a cumulative or a non-cumulative option.
In the cumulative option, the accrued interest is added to your initial investment and subsequent interest instalments are calculated on the initial investment plus accrued interest. And, at the end of the tenure, you receive a lumpsum that comprises the deposited amount as well as the accumulated, compounded interest.
The cumulative option makes sense if the interest payment for a one-year deposit is monthly, bi-monthly, quarterly or half-yearly. For annual interest payments, the cumulative option gives the same return as the non-cumulative option for a one-year deposit! The return will obviously be higher in the former if the tenure of the deposit is more than a year.

How to calculate returns?

Here’s how a cumulative plan differs from a non-cumulative plan: Assume you have invested Rs 1,000 at 11 per cent per annum payable quarterly for one year. At the end of the first three months, the interest works out to
{(1000 x (11/100) divided by 4} or Rs 27.5

In the cumulative option, this interest is added to the initial investment. At the end of the next three months, interest is calculated on Rs 1,027.5 (1000+27.5). The interest now works out to Rs 28.25 and the amount to Rs 1,055.75 (1027.5+ 28.25) In the third quarter, the interest will be equivalent to Rs 29.03, and Rs 29.83 in the fourth quarter. Your returns at the end of the year work out to Rs 114.6 or 11.46 per cent.

In the non-cumulative option, your interest would have been Rs 27.5 per quarter or Rs 110 at the end of the year (i.e., a return of just 11 per cent). The return you receive on your investment is known as the ‘yield’ (as distinct from interest, which is simply a fixed rate offered by a bank or company on your investment).

Which companies are best avoided?

  • Companies that offer very high rates of interest – 16 per cent or above when others offer 12-13 per cent.
  • Companies with poor cash flows.
  • Unincorporated companies or private limited companies – it is difficult to judge their performance in the absence of information.
  • Companies with accumulated losses on their balance sheets.
  • Companies with a poor dividend paying record.
  • Companies that are heavily promoted by brokers.

Here’s a checklist to help you.

NBFCs

The NBFC must have a minimum credit rating of CRISIL or ICRA rating of A-, a BBB rating from Care, or a BBB from DCR India if it is a leasing firm; if it is a loan company, the required rating is A from all agencies.

The finance company should have no overdue deposits, except unclaimed deposits in its books.
The company should be making profits. The company should declare in the deposit application form that it has complied with all RBI directives.

Manufacturing companies

Even though rating is not compulsory for manufacturing companies, go for only AA or AAA rated companies.
Within the same rating grade, choose only a company with a good reputation. Scan business publications to find out how good the company is.
Many companies offer a higher rate on a 13-month deposit than they offer for a year’s deposit. Go for these.
Choose companies with diversified businesses – even if it gets hit in one area, it has a chance of making up elsewhere. Companies like Kotak Mahindra Finance (Kotak Mahindra Friendly Deposit Scheme) are suggested as they have been in the business of car finance, tractor finance, personal finance for years together and also enjoy the highest rating of CRISIL.

Tax treatment of FD’s

The interest income from fixed deposits of NBFCs and manufacturing companies is fully taxable – they are not covered even under Section 80L. Whatever income you earn is to be added to your total income. This is the reason why income tax payees should avoid fixed deposits. For a person in the lowest slab and paying 11 per cent tax after surcharge, investing in a company that pays as much as 14 per cent interest will mean 12.46 per cent after tax. Similarly for a person in the 22 per cent tax bracket, the after-tax return will be 10.92 per cent and for a person paying 33 per cent tax, the after-tax return is 9.38 per cent.

Therefore, fixed deposits of these companies are best suited for people who do not pay income tax. Only fixed deposits of housing finance companies have tax benefits under Section 80L – but they offer low interest rates.

Another issue is of tax deducted at source (TDS). For NBFCs and manufacturing companies, tax is deducted at source at 10 per cent if the interest income is above or equal to Rs 5,000.

There are ways you can avoid TDS. Either break your investment into more than one deposit, in the name of family members if possible, to keep the interest on each deposit less than Rs 5,000 or attach two copies of Form 15H along with the deposit to avoid TDS. But remember that Form 15H is applicable only to those who do not pay income tax.

How do fixed deposits help after retirement?

Your important concern after retirement is the safety of your principal and getting regular, fixed returns. Some companies carry various options of interest payments like monthly, quarterly, half-yearly or even yearly interest. Choose the option that suits you.
Remember a small percentage change in the interest rate will not make much difference to your monthly cheques, so invest in relatively safe companies.

FD Application form and Interest Rates

All the above questions can be answered by a trust worthy and competent financial planner.

For more details contact us