Monthly Archives: March 2015

Protecting future investments against falling interest rates

RBI recently reduced the repo rate twice, thereby, signalling an end to high interest rate regime. With softness in crude prices and inflation, the trend is expected to continue for some time now and experts are talking of some major rate cuts in coming quarters. These cuts in the repo rate shall be a boon to the people who have floating rate loans as the interest rates shall come down and shall impact the EMIs for such loans. However, this also means that the interest rates on fixed income instruments like bank fixed deposits, corporate deposits, bond yield etc would come down proportionately thereby negatively impacting the investors who plan to opt for these instruments in future. These also shall have impact on rates of savings account, PPF, EPF etc that are all market linked.

Before we look at a simple, yet powerful, mechanism of shielding our current as well as future earnings from the vagaries of falling interest rates, let’s have a quick look at how have the interest rates moved in past 15 years.

 Historical Interest Rates

Now, let us assume that ‘Amit’ has a cash of Rs. 10,000 that he wants to invest in a bank fixed deposit. He also expects to have a surplus of Rs. 10,000 per month for next 60 months. Suppose Amit wants to invest these in bank fixed deposit (FDs), he would face uncertainty in terms of interest rate that he can expect on his future FDs. To shield himself, Amit could decide on creating a recurring deposit (RD) for a long duration, say 5 years. This approach of starting a RD shall ensure that the current rate of interest offered by banks on a FD, is fixed for the RD created for the same duration. However, unlike FD, Amit can avail of same interest rate on his future investments, even when interest rates drop in future. Thus RD provides Amit a risk mitigation tool in terms of interest rate fluctuations.

Benefits of RD

  • Interest rate is decided as per current prevailing rate and RD is best mechanism to make future investments interest-rate proof, when we are in falling interest rate regime
  • There is no TDS on RD as opposed to FD where a TDS is deducted at the rate of 10% (if PAN is submitted) and 20% otherwise
  • Proceeds of RD could be utilized for making a big purchase and this acts as an opposite to EMI. In EMI, an item is purchased and EMI is paid in subsequent months (and interest is paid) while in RD, saving is done on monthly basis (and interest earned) and purchase made from maturity proceeds
  • It can be created online just like a FD and has no specific formality

Things to consider while creating RD

  • It has been assumed that the interest rates are going to soften whereas in case interest rates start rising, this approach can be counterproductive albeit, an investor always has an option to liquidate RD with a minor penalty
  • Do not create a single RD rather go for multiple RDs so that in case of a need one can opt for foreclosing one/more RDs instead of the single one. For eg – if Amit wants to create RD for Rs 50,000 per month then he would be better off creating RDs of denomination Rs 5,000, Rs 10,000, Rs 15,000 and Rs 20,000
  • It is also advisable to create RDs for different durations – say maturing every 6 months to ensure liquidity is maintained
  • If an investor has variable surplus each month, don’t go overboard and rather create RD such that there is atleast 1 month advance contribution available

Through this simple mechanism one can be sure of having a fixed rate of interest on ones saving while reaping the benefits of lower interest rates on borrowed money. Over time, it might even happen that the interest being paid on a loan is lower than that earned on a fixed rate instrument.

Happy Fintelligent Investing!!

PS – [Updated on 26th Feb 2016] With effect from 1st June 2015 TDS is applicable on RDs as well.