As soon as you start earning money, everyone old and wise pushes you to invest your hard-earned salary. And like every other rookie on the block, you take your time to learn how important it is to invest your savings.
Once you possess the new found wisdom, you look for avenues to invest wisely. Most people prefer the traditional way of investment i.e. putting your savings in a Fixed Deposit. With guaranteed returns, an FD is the safest bet when it comes to investments.
But what happens when you need money urgently? During financial emergencies, people turn to loans for help, often forgetting the fact that the Fixed Deposit too can help you in providing liquid cash. So during money crunches, you can either break the Fixed Deposit or opt for a loan against Fixed Deposit. Let’s compare the pros and cons of both these options.
Breaking a Fixed Deposit
When you withdraw the principal amount from the Fixed Deposit before its maturity period, it is referred to as breaking a Fixed Deposit. Most people break their FDs either to reinvest in schemes with better returns or to simply deal with unannounced money troubles. However, before you decide to break the FD, these pros and cons need to be kept in mind.
Pros
- Since the rate of interest on Fixed Deposits is sealed and bound to stay the same throughout maturity period, many prefer to break the FD and invest the money in schemes with better returns. If you break a Fixed Deposit when it’s relatively new, you can invest the money somewhere else with higher interest rates.
For example: Mr. Sachin invested Rs. 1 lakh in a Fixed Deposit for four years at an interest rate of 8%. On maturity of the Fixed Deposit, Sachin will gain an interest amount of Rs. 32,000. But after a year, Sachin breaks the FD. When he broke the Fixed Deposit, he earned interest at the rate of 6.5% for the one year the FD was held. After deducting 0.5% as penalty by the bank, Sachin earned Rs. 6,000 as interest at the rate of 6%. Now when Sachin invested the total sum of Rs. 1,06,000 in a new Fixed Deposit with a higher interest rate of 11% for three years, at the end of maturity he will earn Rs. 34,980 as interest. So, he earned a profit of Rs. 2,980 by breaking the Fixed Deposit when it was relatively new.
- Despite the lesser interest rate and penalty imposed by banks, breaking a Fixed Deposit gives you the complete amount you deposited. Thus, you can deal with the money crisis that is making you stare down the barrel.
Cons
- If you withdraw your money before the maturity period, then you will receive a lower rate of interest for the time the FD was held.
For example: Ashok had invested Rs. 2 lakh for a tenure of 5 years in a Fixed Deposit at the interest rate of 9.5%. But after 1 year, he decided to break the Fixed Deposit. So, the interest he will gain after closure will be according to the rate of interest prescribed for a Fixed Deposit held for one year, which is 7 %. Instead of earning Rs. 19,000 as interest at the end of one year, Ashok will only receive only Rs. 14,000 as interest, which is a loss of Rs. 5,000.
- If you break the Fixed Deposit before its tenure, then banks are likely to deduct 0.5 – 1% from the interest as penalty charges. Let’s take the example stated above. We saw that, after 1 year, if Ashok breaks the Fixed Deposit of Rs. 2 lakh for 5 years at interest rate of 9.5% , then he will earn interest on deposited amount only at the rate of 7% (as per interest rate for FD held for 1 year). Now if the bank deducts 0.5% from rate of interest as penalty charges, then Ashok will attain interest only at the rate of 6.5%. This means that Ashok will earn only Rs. 13,000 as interest.
Loan against Fixed Deposit
Also known as the overdraft facility, loan against Fixed Deposit allows you to take a loan up to 90% of the amount deposited in the FD. This option is generally used by people to get financial help during emergencies.
Pros
- Banks provide loan against Fixed Deposit at interest rates 1-2% higher than that of the Fixed Deposit interest rate, which is still better than applying for a Personal Loan at high interest rates.
- Some banks allow you to repay the entire loan with interest, at the time of maturity of the Fixed Deposit. Some banks insist that interest should be paid every month, while the principal amount can be settled after the maturity of the Fixed Deposit.
For example: Sarika, who holds a Fixed Deposit of Rs. 1 lakh for two years at an interest rate of 8%, decides to apply for a loan against FD after six months. The bank offers her a loan of Rs. 90,000 at an interest rate of 9% and requests her to pay the interest every month. One and half years later, when the FD reaches maturity, Sarika would have paid an interest of Rs. 12,150 for the loan. While she can settle the principal loan amount with the principal amount in the Fixed Deposit, the interest earned by her with her FD for two years would be Rs. 16,000. So, despite applying for a loan, she will still make a profit of Rs. 3,850.
- Since it is a secured loan, the paper work is minimal and one can get the loan sanctioned within a day.
Cons
- The tenure of loan cannot be more than the tenure of the Fixed Deposit. Thus you don’t get to choose the period and the rate of interest of the loan.
- Until the loan is repaid, banks don’t allow the closure of the Fixed Deposit.
- If one fails to pay the loan, then the bank settles it by closing the Fixed Deposit and claiming the amount from it.
One should choose wisely between breaking a Fixed Deposit and a loan against FD depending on the situation. If you need money, then loan against Fixed Deposit is the way to go without closing the FD. If you want to reinvest your Fixed Deposit money for better returns, then carefully do the math and decide if it will be truly profitable before breaking the Fixed Deposit. Remember that the best time to break a Fixed Deposit and reinvest it is when it is relatively new.