Along with the interest rate, timing of booking a fixed deposit also plays a crucial role in deciding how much one will be able to accumulate at the end of the tenure. And for those looking to book a big FD for the long term, the time couldn't have been worse. Moreover, if you have an old big FD that was booked say five years ago, which is due for renewal now, the loss on maturity would be substantial. So, is this the time to create an FD ladder?
"Laddering deposits is a way to stagger your investment into multiple accounts of varying intervals to earn high returns with regular liquidity," says Adhil Shetty, CEO, Bankbazaar.com. Here is a look at how you can use the ladder in fixed income investment to optimise your returns.
Not the right time for renewal of a big FD
While keeping all eggs in one basket, or keeping one big FD of a long tenure, is a bad investment strategy in general, it has become all the more evident in the current economic situation. The fall in interest rate in the last 4 years has been very steep as the repo rate which was at 6.75% in August 2018 fell by whopping 3.75% to 4% in May 2020 and it has remained there since then. The State Bank of India's (SBI) 5-year FD interest rate which was at 9.25% till the beginning of the year 2012 has now come down to 5.40% at present.
So, if there as big long-term FD which is due for renewal, then doing so now will result in locking all your deposit at possibly the lowest interest rate.
The right time to plan an FD ladder as interest rates reverse
Governments world over infused enormous liquidity into the economy during the coronavirus pandemic which has resulted in higher inflation globally. As inflation rises interest rates are likely to follow suit. "We expect the RBI to start policy normalization with a reverse repo rate hike in February. We expect repo rate hikes from the April policy meeting, with cumulative hikes of 125 bps in 2022 - more hawkish than consensus - in view of improving and broad-based growth and likely Fed tightening," says a Morgan Stanley research report dated January 19, 2022.
SBI has raised the interest rate of FDs with tenure of 1 year to less than 2 years from 5% to 5.10%. SBI has hiked FD rates after a gap of more than a year. So, when the interest rate is likely to go up, booking a big FD at this point in time will lock your investment at a lower rate for a long period. However, now might be the right to go for a FD ladder.
How a fixed deposit ladder is made
Let us understand what an FD ladder is. As a first step in making an FD ladder, rather than booking one big FD for a long tenure you have to divide it into various parts. "Assume you have Rs 3 lakh at hand. Instead of investing it as a lump sum for a span of 3 years (2-3 years is usually the peak interest tenor), you split it into 3 FDs of Rs 1 lakh each, the first for 1 year, the second for 2 years, and the third for 3 years. So, you end up investing all the cash in 3 different fixed deposits, each maturing one-year apart, essentially creating a ladder," explains Shetty.
"At the end of the first year, you renew the matured FD for 3 years, creating the next rung. The year after, the FD with the 2-year tenor matures, and you reinvest it for 3 years, creating yet another rung. This means you have liquidity at the end of every year," adds Shetty.
Similarly, one can go for an FD ladder with a 5-year tenure with annual interval as shown in the table below.
How FD ladder can help
Here are the 4 ways an FD ladder can make the difference.
Avoid minimum return: The interest rate risk is highest if you book your big FD at one go at a lower rate and find the rate going higher later on. However, in a FD ladder, you divide the amount into smaller FDs and book them one by one after a good interval spreading over 3-5 years from first FD to the last FD. With a long gap between the first and the last FD in the ladder the chances of your FD earning the lowest rate is significantly reduced.
Prevents from timing the interest rate cycle: Every depositor would ideally like to book their FDs at the highest rate, but interest rate cycle always keeps moving hence it may not be feasible when the interest rate is falling. "One of the risks of depending on FDs is reinvestment risk - namely, the reinvestment may not be at the same rate on maturity. Having different amounts maturing at different times and preferably linked to when the funds are needed for goals reduces this risk," says Lovaii Navlakhi, Chairman, Association of Registered Investment Advisors (ARIA). When you go for an FD ladder, you don't have to speculate the interest rate movement to look for a better time to book your FD. It will become time independent as you need to book FDs as per your ladder requirement.
This will result in averaging the interest rate movement as some of the FDs may get booked at lower rates, but a good part will also get booked at a higher rate. Though you may not be able book all your FDs at the highest rate when you make an FD ladder, but it will prevent you from getting the lowest rate on all your investments as you will get the average interest rate during the spread of your FD ladder.
Get the best rate on offer: The rate of interest offered by banks varies across tenures. Usually, the best return of fixed deposit is given on the long-term tenure ranging 3-5 years. For instance, SBI offers an interest rate of 5.10% on FDs with tenure from 1 year up to below 5 years, whereas, it offers the highest interest rate of 5.40% on 5-year tenure. As the ladder gives you the liquidity at desired intervals you can still book all your FDs for long-term tenure of 5 years. So, despite dividing your big FD into several small FDs the FD ladder allows you to go for long-term tenure to get the benefit of higher interest rate of the bank.
Have ample liquidity without breaking FDs: One of the unique advantages of an FD ladder is that you get regular liquidity. "Fixed deposits are meant to stay invested till maturity and longer the maturity period, the higher the returns. The constraint here is the low liquidity. This is where laddering helps. Laddering deposits is a way of staggering out your investment into multiple fixed deposit accounts of varying terms to earn high returns, with liquidity at regular intervals," says Shetty.
In case you have booked an FD for long tenure and need the money mid-way you may have to break the FD often at a loss. "Generally, banks will charge some extra amount when you opt for premature withdrawal. Laddering deposits mean liquidity at regular intervals, which can help reducing losses from premature withdrawal," says Shetty.
However, in an FD ladder the amount is divided into small parts with each part maturing at different points in time. It gives you many windows of liquidity without any need of breaking your FDs midway through their tenure. "Contrary to what most people believe, laddering is a very critical investment principle and is applicable to all goal-based fixed-tenor investments and not just FDs alone. The idea is to have sufficient liquidity at regular intervals," says Shetty.
Ideal tenure and interval between two consecutive FDs
If you keep the tenure short the liquidity will be higher but the return that you would get would be on the lower side. Banks usually give their best interest rates on FDs ranging 2-5 years. So, having a tenure in this range will make sure that the tenure gives you higher return.
When it comes to interval between two consecutive FDs it will primarily depend upon your liquidity need. If you need liquidity frequently, you can have shorter intervals. "The minimum period could be 15 days to one month for short term FDs and one quarter (three months) for longer tenures," suggests Navlakhi. However, if your liquidity requirement is not urgent, then going for an annual interval will also be a good option.
FD ladder of tax saving FDs
Tax saving FDs which allow you to invest Rs 1.5 lakh in a given financial year can also be used for making an FD ladder and enjoying the deduction of Rs 1.5 lakh each year under section 80C. For this you can book Rs 1.5 lakh tax saver FDs with 5-year tenure each year for 5 years and then keep renewing them for another 5 years.
"You can apply the laddering principle to fixed income instruments including Bank or Company FDs, NSCs, KVPs, etc." says Shetty.
What you should do
Making an FD ladder is one of the best strategies to manage fixed income instruments and investors who primarily depend upon fixed income instruments, especially senior citizens, can use it effectively to enhance their return and manage liquidity in the investment. "While FDs and other fixed return instruments may not provide you the best returns out there, they still provide ensured steady returns regularly. This makes it ideal for senior citizens who have lump sum retirement funds to invest," suggests Shetty.
