Premature Withdrawal of Fixed Deposits: Why You Should Avoid Breaking FDs

Due to the rising interest rates, Fixed Deposits (FDs) have become a popular investment choice for many Indians, particularly those seeking low-risk and steady-income financial products. Nevertheless, before investing in FDs, it is crucial for investors to comprehend the distinct types of FDs available and the rules related to premature withdrawals of Fixed Deposits in case of unforeseen circumstances.

What Is Premature Withdrawal of a Fixed Deposit?

Fixed Deposits (FDs) have varying durations, starting from as little as 7 days up to 10 years, where the invested funds generate interest at a fixed rate for a set period. While FDs have a predetermined lock-in period, in case of an unforeseen circumstance, individuals can opt for premature FD withdrawal, either in part or in full. In some cases, investors may opt to withdraw money from an FD before the maturity date if they discover a more attractive investment alternative.

What Is the Penalty for Premature FD Withdrawal?

Early withdrawal incurs additional fees as a penalty charged by the financial institution, which diminishes the actual interest rate of the FD. Typically, the penalty for premature FD withdrawal falls within the range of 0.5% to 1%. Nevertheless, certain banks do provide the option of withdrawing funds early without incurring penalty charges. However, it is important to note that if an FD is closed prematurely within 7 days of opening the account, the bank or NBFC is not obligated to pay any interest.

But, How Does a Percentage Cut in the Interest Rate of an FD Affect Your Investment?

Most banks penalise for premature FD withdrawal in this way:

Suppose you invested Rs 5 lakhs in an FD for three years at an interest rate of 7.5% p.a. However, after one year, you withdraw the FD. Let's say at the time you booked the FD, the interest rate for a one-year term was 7% p.a. You have already earned interest at the rate of 7.5% p.a. for the first year, but the bank will recalculate the interest rate based on the effective FD rate of 7% minus 1%, which equals to 6% p.a. This new interest rate of 6% p.a. will apply when you prematurely withdraw your FD after 1 year, resulting in a lower interest pay-out. However, take note that your principal amount remains unaffected, and only the interest earned will be subject to a penalty.

While this is the most commonly used method to calculate the penalty for bank fixed deposits, some banks calculate it as below:

Let's assume you invest Rs 5 lakh in an FD at a 7% p.a. interest rate for 3 years, and at the time of booking, the interest rate for 1 year is 7.5%, and the penalty for premature withdrawal is 1% of the effective rate of interest. The effective interest rate is the lower of the interest rates at which the fixed deposit was initially booked and the rate applicable for the period that the FD has been held in the bank.

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If you withdraw the FD after 1 year, you will have earned interest at a rate of 7% for that year. However, the bank will recalculate the interest at an effective FD rate of 6% p.a., which is the previous rate of 7% minus the 1% penalty. The new rate will be 6% p.a., and the customer will receive interest payments at this rate instead of the 1-year FD interest rate (at the time of booking) of 7.5% p.a.

The penalty for premature withdrawal of Post Office Time Deposits works in this way:

Regarding Post Office Time Deposits, you can make a premature withdrawal six months after opening the deposit. However, if you withdraw funds before the maturity period, you will be subject to a penalty.

If you close your TD account after six months but before one year, you will receive interest at the Post Office Savings Account interest rate. On the other hand, if you close a 2/3/5 year TD account prematurely after one year, the interest rate will be calculated at 2% less than the TD interest rate for the completed years.

NBFC premature FD withdrawal works this way:

NBFC Fixed Deposits carry a mandatory lock-in period of at least 3 months. If you prematurely withdraw your deposit within 3 to 6 months, only the principal amount is refunded, and you will not receive any interest on it. Whereas, if you withdraw your deposit after 6 months, your interest earnings will be calculated at a rate that is 2% lower than the applicable interest rate.

How Can You Avoid the Premature FD Withdrawal Penalty?

If you are not sure about choosing the right FD tenure or are worried about not having enough cash readily available, you can consider a sweep-in Fixed Deposit (Sweep-in FD). This type of FD, also referred to as a 2-in-1 account, offers both the advantage of liquidity from a savings bank account and the interest rate of an FD. Any amount over the savings account's threshold limit is automatically transferred to the FD account. If your savings account balance becomes low, withdrawals are made from the FD account and transferred back into the savings account. Moreover, many banks nowadays allow you to choose the threshold limit as per your preference.

You can also consider taking a loan against a Fixed Deposit if you hold the FD and have the capacity to repay the loan amount within the loan agreement period. It can be obtained by using your fixed deposit as collateral. Typically, banks offer loans ranging from 85% to 95% of the fixed deposit amount, while Non-Banking Financial Corporations (NBFCs) offer loans up to 75% of the deposit amount. The interest rate for this loan is typically 0.5% p.a. to 2% p.a., higher than the existing fixed deposit interest rates. However, if you have a long-term financial goal that you cannot compromise on and are uncertain about your capacity to repay, it is not advisable to risk your fixed deposit.

KETKI JADHAV is a Content Writer at PersonalFN since August 2021. She is an MBA (Finance) and has over seven years of experience in Retail Banking. Ketki specialises in covering articles around banking, insurance, personal finance, and mutual funds and has been doing it for over three years now.