Why You Should Resist Withdrawing from a Bank FD

As interest rates climb, the appeal of FDs as a low-risk, steady-income investment option amplifies, attracting diverse investors. Yet, the decision to invest in FDs is generally taken only considering prevailing interest rates. However, the lack of understanding of your financial situation and investment goals and the absence of research can lead to premature withdrawal of bank FDs.

This article elucidates the imperative reasons investors should exercise caution before hastily withdrawing from a Bank FD. You can navigate the FD landscape prudently by examining the dynamics of interest rates, the intricacies of FD variants, and the consequences of premature withdrawals. This will also help you make informed decisions and safeguard your financial interests. In this article, we are focusing on the consequences of withdrawing from a Bank FD prematurely and why you should resist it.

What Is Premature Withdrawal of a Bank FD?

A fixed deposit, provided by banks and other financial entities, allows investors to deposit a lump sum for a specific duration at a predetermined interest rate, ensuring a fixed return on the investment. However, circumstances may arise where accessing the funds before the agreed-upon maturity period becomes necessary.

When funds are withdrawn from an FD before its maturity date, it is called a premature withdrawal. Financial institutions typically implement provisional protocols for such scenarios, addressing their own macro-financial concerns, such as balancing depositor interests and ensuring liquidity. In the subsequent section, we will examine the implications of opting for premature withdrawal from your FD in detail.

[Also Read: Bank Fixed Deposits: Why This Could Be Your Investment Sweet Spot in 2024]

What Are the Consequences of Premature Bank FD Withdrawal?

1. Penalties and Fees:

A critical aspect to consider before the premature withdrawal of a Bank FD is the penalties and fees associated with it. While these charges vary among institutions, they typically entail a reduction in the interest rate.

Banks enact this measure to offset the loss incurred due to early withdrawals. The interest rate reduction often falls within the range of 0.5% to 1%, sometimes even higher. Therefore, it is essential to thoroughly review the terms and conditions outlined in your FD agreement to know the specific penalties and fees that apply.

2. Impact on Interest Accrual:

An FD's primary benefit lies in its provision of compound interest. This mechanism entails reinvesting interest earnings back into the principal amount, leading to amplified returns over time. However, premature withdrawal usually triggers adjustments in the interest calculation. Consequently, you may lose a portion of the interest that would have accrued had the deposit been maintained until maturity.

FD Compound Interest Calculators can be useful for gauging the potential impact on your interest earnings. These online tools consider factors such as principal amount, interest rate, tenure, and penalties for early withdrawal to furnish an approximate estimation. Nonetheless, the actual interest loss might vary slightly as different banks use distinct methods for calculating the adjusted interest.

3. Taxation:

Another crucial consideration when considering premature FD withdrawal is its implications on tax liabilities. The interest earned from FDs is subject to taxation, with tax deductions executed at the source by the bank (TDS). However, withdrawing your deposit before maturity necessitates an adjustment in the TDS calculation based on the reduced interest rate applicable to premature withdrawals.

Consequently, the recalculated TDS amount may induce fluctuations in your tax obligations. Seeking advice from a tax professional is advisable to understand the tax implications and any requisite adjustments that need to be made.

[Also Read: Fixed Deposits vs Recurring Deposits: Which Is Better for You?]

How Does a Reduction in FD Interest Rate Impact Your Investment?

Many banks implement penalties for early FD withdrawal using this method:

Suppose you invest Rs 10,00,000 in an FD for three years at an interest rate of 8% per annum. However, you decide to withdraw the FD after one year. At the time of opening the FD, the interest rate for a one-year term was 7.5% per annum. While you have already earned interest at the rate of 8% per annum for the first year, the bank will adjust the interest rate based on the effective FD rate of 7.5%, minus the 1% penalty, resulting in an effective rate of 6.5% per annum.

Hence, when you withdraw the FD prematurely after one year, you will receive a lower interest payout with an effective interest rate of 6.5%. It is important to note that only the interest earned will be subject to a penalty, while the principal amount remains unaffected.

Principal amount: Rs 10,00,000

The interest rate for a 3-year FD (at the time of opening): 8% per annum

Maturity amount after 1 year: Rs 10,80,000

The interest rate for 1-year FD (at the time of opening): 7.5% per annum

Penalty for premature FD withdrawal: 1% on the rate for the tenure that the FD remains with the bank

Final applicable interest rate: 6.5% per annum (7.5% - 1%)

Premature withdrawal amount: Rs 10,61,000

While this method is commonly used to calculate penalties for premature withdrawal, some banks use a different approach:

Let's say you invest Rs 10,00,000 in an FD at a 7.5% per annum interest rate for three years. At the time of opening the FD, the interest rate for a one-year term is 8%, and the penalty for premature withdrawal is 1% of the effective interest rate. The effective interest rate is determined as 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.

How to Avoid Premature FD Withdrawal Penalties?

If you are uncertain about choosing the appropriate FD tenure or concerned about maintaining sufficient readily available cash, you can consider a sweep-in Fixed Deposit (Sweep-in FD). This type of FD, also known as a 2-in-1 account, provides the benefits of liquidity from a savings bank account and the benefit of an FD's higher interest rate.

Any surplus amount beyond the savings account's threshold limit is automatically transferred to the FD account. In case your savings account balance dips, withdrawals are facilitated from the FD account and transferred back to the savings account. Furthermore, many banks offer the flexibility to set the threshold limit according to your preferences.

Alternatively, you could explore the option of getting a Loan Against Fixed Deposit if you hold an FD and have the capability to repay the loan amount within the specified period stated in the loan agreement. This type of loan is secured by using your fixed deposit as collateral.

Typically, banks extend 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 such loans typically ranges from 0.5% p.a. to 2% p.a., higher than the prevailing fixed deposit interest rates.

However, it is important to note that if you have a long-term financial objective that you cannot compromise on and have concerns about the uncertainties of your repayment capacity, risking your fixed deposit by using it as collateral may not be a good choice.

[Also Read: 7 Things to Consider Before Investing in Fixed Deposit]

To conclude:

The decision to withdraw prematurely from a Bank FD requires careful consideration due to its potential consequences. While unforeseen circumstances may necessitate early access to funds, understanding the penalties, reduced interest earnings, and tax implications is crucial.

Exploring alternative options like sweep-in FDs and Loans Against FDs can offer viable solutions without compromising long-term financial goals. Resisting the urge to withdraw prematurely can ultimately lead to enhanced financial stability and growth.

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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.

Disclaimer: Investment in securities market are subject to market risks, read all the related documents carefully before investing.
This article is for information purposes only and is not meant to influence your investment decisions. It should not be treated as a mutual fund recommendation or advice to make an investment decision in the above-mentioned schemes.