The Great Rate Escape: Examining the Impact of Rising Interest Rates on Your Fixed Deposit Aspirations
While investing in a fixed deposit, investors usually feel safe, secure, and assured about returns. And that’s true. Fixed deposits have long been a bankable investment avenue, especially for those looking to earn a steady periodic interest and safeguard their principal amount. However, did you know, fixed deposit interest rates fluctuate and whether rising or declining, they can affect your fixed deposit returns? Yes! So, let’s examine a few aspects of changing interest rates on your fixed deposit returns.
What is a Fixed Deposit?
Most of you would already know what fixed deposits are. However, for those who are new to the world of fixed deposits, here’s an overview of what fixed deposits are. So, fixed deposits are a financial instrument usually offered by banks and other financial institutions. They require depositors to invest a specific amount for a particular duration (ranging from seven days to ten years) and at a predetermined interest rate. Accordingly, some also address fixed deposits as term deposits.
Some essential features of a fixed deposit include fixed interest rates, fixed tenure, periodic interest payments (monthly, quarterly, or yearly as chosen by the depositor), return of principal upon maturity, liquidity, and safety.
Fixed interest rates may excite many. However, what if there’s a change in the interest rates due to inflation, the country’s economic policy, or any other reason? That’s something everyone should consider before opening a fixed deposit. Here’s more to it.
The Role of Interest Rates in Fixed Deposits
Fixed deposits usually offer guaranteed returns. However, their interest rates change over a while and impact fixed deposit returns. Rising interest rates can increase fixed deposits. On the other hand, a decline in the interest rates affects the returns adversely. But why do banks revise fixed deposit rates and which factors impact fixed deposit interest rates? Here’s the answer.
Why Banks Revise Fixed Deposit Rates?
Banks operate as part of the broader economic landscape of a country. Hence, the fixed deposit returns they offer aren’t devoid of external economic circumstances and factors like the repo rate of the Reserve Bank of India (RBI). Hence, banks revised fixed deposit interest rates regularly to keep up with the existing market conditions.
Speaking of the repo rate, RBI reviews it periodically and makes changes to it. The repo rate has a direct relation with your fixed deposit interest rate. Hence, changes to the repo rate can impact the latter, no matter whether it is a bank or a NBFC fixed deposit.
The RBI's Monetary Policy Committee (MPC) sets the repo rate that serves as a benchmark interest rate. The repo rate impacts the cost of borrowing to banks and that affects various financial markets, including fixed deposits. MPC sets the repo rate based on its evaluation of inflation and other economic factors. Inflation affects savings interest rates, including fixed deposits and the purchasing power of the returns investors earn on them. It determines the investment’s real value over time and the amount one would pay for a fixed deposit compared to its inflation-adjusted value in cash.
Apart from repo rates, banks revise fixed deposit interest rates based on inflation and competition with other financial institutions. Let’s look at the various factors influencing the interest rates of fixed deposits.
Factors Impacting Interest Rates
Here are some factors that significantly drive interest rates.
A Country’s Economic Condition
Interest rates increase amidst a flourishing economy due to an increase in demand for credit. However, amidst a floundering economy, interest rates fall to trigger borrowing and spending. In the latter situation, fixed deposit returns are likely to reduce.
Central Bank Policy
Another vital aspect with a say in a country’s fixed deposit interest rates is the country’s bank. The bank has the power to increase or decrease interest rates to control inflation and foster economic growth within the country.
Inflation Rate
As we mentioned a couple of times earlier, inflation also has a critical impact on interest rates. High inflation causes lenders to charge higher interest rates to compensate for the reduced purchasing power of the money they provide.
Government Policies
Government policies are as crucial in fixed deposit interest rates as they are in other areas. Tax reductions or increased spending can impact interest rates. For example, if the government increases its expenditures, it can scale up the demand for credit and cause the interest rates as well to increase.
Repo Rate
With a repo rate reduction, banks may reduce their fixed deposit interest rates to promote lending and economic growth. On the other hand, if the repo rate increases, banks may increase their fixed deposit interest rates to call upon more deposits.
Global Economic Situation
The world is an economically small place where one country’s economic crisis can impact another country’s economy. And when economic downwaves like recession grip a country, they can impact its interest rates negatively.
How do Interest Rate Changes Affect Fixed Deposit Returns?
While you’ve now seen some of the vital factors responsible for changes in interest rates, let’s see how changing interest rates affect fixed deposit returns.
Increase in Returns with Higher Interest Rates: Higher interest rates increase fixed deposit returns, making the latter a more attractive investment avenue.
Negative Effect of Inflation: High inflation is bad for every economy. While reducing people’s spending capacity, it can cause a noteworthy reduction in the actual returns of a fixed deposit. If inflation rates surpass the interest rate of the fixed deposit, it is evident that the actual value of the investment will also erode.
Fund Lock-In Opportunity Cost: A rise in the interest rates makes fixed deposits more lucrative. However, such fixed deposits come at a cost. They require you to lock in your funds for a particular period. Such terms and conditions can compel you to compromise your investment aspirations. You wouldn’t be able to leverage other investment options amidst rising interest rates, as you would have already locked a significant amount of your funds in a fixed deposit.
Impact on Longer Tenure Fixed Deposits: Fixed deposits invested for a longer time remain exposed to interest rate changes for a longer time. Hence, they are more affected than those with shorter tenures.
Effect on Reinvestment: Often, people keep reinvesting their fixed deposit at maturity. However, interest rate variations can impact the returns on reinvestment. For example, if the interest rate at the time of reinvestment is lower than earlier, reinvesting the fixed deposit amount will yield lower returns.
Why Different Institutions Have Varying Fixed Deposit Interest Rates?
Fixed deposit interest rates depend on the bank or the financial institution's ability to repay the fixed deposit. You can measure a financial organization's financial health by its capital level. For instance, a high capital level signifies abundant funds to compensate for losses and maintain lower operational costs. The fixed deposit rate denotes the institution’s financial muscle.
How to Deal with Fixed Deposit Interest Rate Changes?
An increase in fixed deposit interest rates applies to all tenures. Long-term fixed deposits are affected more than their shorter counterparts. Amidst high-interest rates and increasing inflations, one may consider opening a short-term fixed deposit. Once the inflation settles, they can go for a long-term fixed deposit.
Besides, you can split a large deposit into smaller fragments deposited for varying tenures to get the periodic liquidity and interest rate volatility advantage.
Thus, when the interest rate volatility is high, you can opt for a shorter tenure fixed deposit. On the other hand, if the fixed deposit interest rate is high, you may invest the money for longer. It is obvious not to keep your money locked for a long time in debt instruments, especially when the economy is grappling with soaring inflation.
Final Words
So, you’ve seen how interest changes affect your fixed deposit returns. It isn’t bad to invest in fixed deposits. However, you should spread the risk to multiply your returns through other investment avenues with potentially higher yields to offset the inflation and interest rate impact. Bonds can be one among them. Explore our articles on bond investments and how they can help you deal with various economic situations. Sign up with us to access reliable bond options and invest in them seamlessly.
Disclaimer:
The contents of this article should not be construed as tax or financial
advice. Readers should seek advice from their tax or financial advisor before
making any investment decision.