Should you switch your deposit?



If you had invested a year ago in bank term deposits with long term maturity of over two years, you would be missing out on the current interest rate uptrend. Interest rates on deposits have gone up by over 2 per cent for varying maturities since September 2010. Given the significant variance in interest rates offered a year ago and now it makes sense for investors who hold deposits (invested last year) with over a two-year maturity to foreclose and reinvest in high yielding deposits now.

Background

The first half of the year 2010, was a period of rock-bottom deposit rates, failing to beat the double digit inflation that prevailed then.

The one-year retail deposit rate for instance was as low as 6 per cent in case of SBI. However, the continuous policy rate hikes by the RBI coupled with liquidity squeeze has resulted in significant rise in interest rates both on the deposit and loan front.

Last year, Business Line recommended its readers to lock-into the short-term rates as there was high probability of rates going up. The current interest scenario provides an opportunity to move to high yielding long-term deposits.

Cost of pre-closure

Investors who have locked their money at lower rates, can opt to preclose depending on the residual maturity period of their deposit. Before we move to discuss who should preclose, we take a quick look at the cost of closing a term deposit before maturity which typically includes prepayment penalty and lower rate of interest for the period held (during a rising interest rate scenario).

On pre-mature withdrawal of the deposit, interest rate will be calculated at the rates applicable for the period the deposit has actually remained with the bank. The interest rate would be the rate that was prevailing when the individual opened the term-deposit. For instance, consider a case where a depositor locked into ICICI Bank's 7 per cent deposit with a maturity period of 2-3 years in May 2010 and wants to exit this year. Having held for only a year, the depositor's return will be calculated taking into account ICICI Bank's one-year deposit rates (which was 6.5 per cent) that prevailed a year ago. In addition this lowered interest rate, the depositor would also be charged a pre-closing penalty of 0.5-1 per cent by the bank.

This penalty is mostly levied irrespective of whether the depositor reinvests in the same bank or moves to a different bank. As a depositor it is therefore important to assess whether the new interest rates that you will lock in to will compensate for the above charges. A few banks though, do not charge penalty if you reinvest in the same bank for a term longer than the residual period.

Should you pre-close?

Before deciding to prematurely close your deposit, scout for banks that offer the best interest rates (See Business Line'sSunday edition for the deposit rate table to get an idea on the prevailing rates across banks). Foreclosure to reinvest doesn't really benefit a depositor if the spread between the old deposit rate and the new deposit rate net of charges incurred on pre-closure, is too thin. For instance, if a year ago, you had locked in to rates that were about 7-7.5 per cent for a two-year deposit and want to break it now and avail higher interest rates for the remaining one-year period, you should get well over 8.5-9.5 per cent to earn some additional returns, over and above all the charges. However, currently the maximum one-year deposit offered is 9.25 per cent. Hence, there is no incentive to pre-close for those who hold deposit for less than two years.

For depositors who locked in to terms beyond two years, it makes sense to pre-close and lock-in to higher rates.

Post foreclosure penalty, for a 7-7.75 per cent three year deposit, the break-even would be between 7.7 per cent and 8.6 per cent. In other words, if you can now get interest rates above the break-even mentioned, you would benefit from pre-closing and reinvesting.

Currently, the two-year and above deposits are available at an attractive 9-9.75 per cent. State Bank of Bikaner and Jaipur (SBBJ) offers 9.75 per cent for a 2-3 year deposit. Special deposit rates can also be considered as they continue to give attractive rates.

Longer periods

The above strategy can be followed if depositors want to invest for the remaining period of their original deposit. However, if you can lock-in to longer periods, there are more attractive options available.

The three year options offered by Syndicate Bank (9.5 per cent), Lakshmi Vilas Bank (9.5 per cent), IDBI Bank (9.25 per cent) and Corporation Bank (9.25 per cent) to name a few would yield superior returns.

The current tax saving scheme of SBBJ (9.75 per cent rate of interest), gives a annualised yield of 16 per cent for an investor in the 30 per cent tax bracket.

The yield comes to13.5 per cent and 11.5 per cent for an investor in the 20 per cent 10 per cent tax bracket respectively. This return is currently higher than most of the Section 80C savings instruments such as NSC.

However, 80C benefit for term deposits will be lost by end of this year as DTC kicks in the next fiscal. Therefore current high rates can be viewed as an opportunity to lock-into these deposits.

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