Home/ Money / Interest rates matter: risks and rewards of locking in FDs

Interest rates are currently peaking in several economies, including the US and India. The Federal Reserve in the US and the Reserve Bank of India (RBI) have been gradually increasing rates to curb inflationary pressures and maintain economic stability. In India, inflationary concerns have been heightened by rising global commodity prices, elevated crude oil costs, and increased government spending. As a result, the RBI has adopted a hawkish monetary policy stance, raising key policy rates to rein in inflation.

This presents an opportune time for investors to consider fixed deposits (FDs) and lock in at high rates. Indian FD rates have been on an upward trajectory, reflecting the tightening monetary policy and the aim to attract deposits.

Why lock in rates?

Locking in interest rates when investing in FDs provides certainty regarding the interest income that will be earned over the duration of the investment. This offers a predictable cash flow, which can be advantageous for financial planning purposes or when aiming to align cash inflows with specific future expenses or goals.

During different interest rate cycles, the decision to lock in rates can have varying outcomes. For example, if an investor locks in an FD at a higher interest rate during a period of low rates, they will continue to earn the higher rate until the FD matures. This can result in greater returns compared to investors who enter into FDs at lower rates when interest rates rise later on. On the other hand, if interest rates increase after investing in an FD, the locked-in rate may become less favourable compared to the higher rates available. In such cases, investors may miss out on the opportunity to earn higher returns until the FD matures and can be reinvested at a new, potentially higher, rate.

To better understand the risks associated with locking in interest rates, let’s consider an example. Suppose an individual invests 20 lakh in an FD for a duration of 3 years at an interest rate of 8.5% during a period of low rates. With annual compounding, the investment would generate approximately 5,43,527 in interest income over the 3-year term.

However, if interest rates were to rise to 9.5% after a year, and the individual reinvested the maturity amount in a new FD at the higher rate, the potential interest income for the remaining 2 years would be approximately 603,512.

By locking-in interest rates at a time when rates could move up, investor loses an additional interest of 60,000. In this scenario, by not locking in the initial rate for the full 3 years, the investor would benefit from the higher interest rate and earn a higher overall return on their investment.

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Updated: 26 May 2023, 01:34 AM IST
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