Why The Highest Fixed Deposit Rate Might Not Be The Best Option For You

Banks have been raising the interest rates offered on fixed deposits at regular time intervals. This is being done in order to meet their funding requirements for their operations because the demand for loans is far greater than the inflows coming in from deposits. Overall, interest rates in the economy, too, have not seen any perceptible decrease.

All these factors leave banks with little option but to raise interest rates to attract investors and put their money into fixed deposits.

While this is good news for the investors, they need to be careful before jumping to the highest-rate option that is available on the deposits.

One of the factors that determines the interest rate on fixed deposits offered by the banks is the need for funds for a specific time bucket. Each bank has its own individual situation, wherein they need money for lending for different periods of time. This makes it important for them to ensure that they are getting adequate funds for the time period that they need them for; otherwise, it leads to an asset-liability mismatch. This is why you will find that often, when there are changes in the interest rates, the banks do not raise them to the same extent for all the time periods of deposits. Ultimately, it leads to different rates for different time periods with each bank. This requires some effort by the investor while selecting a bank and the time period while investing in a FD. 

Investors have an expectation that they will get a higher rate if the time period of the fixed deposit rises.

This can be true for some banks, but it need not be there for every bank, and that too at all time periods. It is common to find that there are higher rates for some shorter-term deposits as compared to longer-term deposits.

The banks offer deposits that stretch up to several years, including those that can be for a decade, so the time period is an important component of the deposit selection. The variation of the rates for the time periods has to be considered carefully so that the right decisions are made.

The interest rate that is offered has to be seen in the context of the time period for which they are available because the highest rate might not be the best on offer for the need of the individual.

If the idea is to lock in the money for a longer time period and get the best rate possible, then there would be a need for a calculation to see the kind of situation that the investor is going to face.

For example, if a bank is offering 7.25% for a three-year deposit and 7.5% for a one-year deposit, then the rate for the one-year deposit is higher, and this might look attractive. But there is a big risk involved here, because if the investor needs to deploy the money for three years, then in the first option they know that their return is locked in at 7.25%.

In the second option, after one year, there is uncertainty about the rate that is prevailing at that point in time. If the rates have dipped, to say 6.5%, at the time of reinvestment, the investor will then earn a lower rate of return. Over the entire three-year time period, they might end up with lower earnings as compared to what they would have gotten had they just selected the three-year time deposit at the initial time period itself.

This is important because the uncertainty surrounding the reinvestment can impact the final returns, and the investor needs to make a choice as to what they will go with. Ultimately, it's not just the interest rate that matters, but also the time period for which it is offered and the time horizon of the individual investor.

Arnav Pandya is founder Moneyeduschool