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Many times in life, there is an immediate need for money due to sudden medical emergency, children’s school-college fees, home repair or any unexpected financial crisis. At such times, most people turn to their safe savings i.e. Fixed Deposit (FD). But the biggest dilemma here is whether the FD made after years of hard work should be broken midway or whether the same FD should be mortgaged and a loan or overdraft facility should be taken from the bank?
According to financial experts, breaking FD without thinking can cause double financial loss to you. Not only do banks charge a penalty on premature withdrawal, but the cycle of compounding interest you get is also broken forever. On the other hand, the option of taking a loan against FD gives you the freedom to overcome cash crunch while keeping your deposits safe. The right choice for both the options depends on how much money you need and how much time you can repay it.
When you close a fixed deposit before completing its tenure, banks call it ‘pre-mature withdrawal’. In this, the returns you get get reduced on several parameters:
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Deduction of penalty: Major banks of the country (like SBI, HDFC, ICICI, PNB) deduct a penalty ranging from 0.50% to 1% for premature breakage of FD.
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Applicable interest rate rule: Suppose you had made an FD of ₹ 5 lakh at the rate of 7.5% for 5 years. If you break it after 2 years, the bank will not give you 7.5% interest for 5 years. The bank will pay interest at the rate which was applicable for a period of 2 years at the time of opening the FD (let’s say 6.5%), and after deducting 1% penalty from that, it will pay you only 5.5%.
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Major disadvantages of compounding: The biggest long-term benefit of FD comes from interest earned on interest i.e. compounding. Breaking the FD midway completely stops the wealth creation process of future years.
Taking loan against fixed deposit comes under the category of secured loan. In this, your FD remains safe with the bank as collateral:
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Loan limit: Banks immediately approve 85% to 95% of your FD’s total deposit amount and the interest earned on it in the form of loan or overdraft.
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Interest rate formula: The interest rate on loan on FD is very normal. Banks usually charge only 1% to 2% more interest than the basic interest rate on your FD. For example, if your FD is getting 7% interest, then the interest on the loan will be 8% to 8.5%.
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Interest continues on the entire FD: Despite taking the loan, the 7% interest fixed by the bank continues to accrue on your entire FD of ₹5 lakh.
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Flexible Repayment (Overdraft Facility): In this facility you get a credit limit. You have to pay interest only on the amount of money you withdraw and the number of days for which you use it.
Let us assume that you have made an FD of ₹5,00,000 at 7.00% annual interest for a tenure of 5 years. After completion of 3 years you suddenly need ₹2,00,000 for 6 months. Let’s look at the actual financial analysis of both situations:
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Option 1: Breaking FD prematurely
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The actual 3-year card rate was 6.25%, after deducting 0.75% penalty, the effective rate was 5.50%.
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You will get 3 years of interest at a lower rate and the remaining 2 years of compounding benefits will be completely eliminated.
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Your entire FD of ₹5 lakh will be lost, whereas all you needed was ₹2 lakh. Future interest of 7% will be stopped on the remaining ₹3 lakh also.
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Option 2: Take overdraft/loan of ₹2 lakh against FD
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Your entire FD of ₹5 lakh will continue to grow at the rate of 7% and will give its full maturity value after 5 years.
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You will have to pay interest at the rate of 8% (7% + 1%) for 6 months on a loan of ₹2 lakh, which will work out to around ₹8,000.
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After 6 months, as soon as you repay the interest of ₹2 lakh and ₹8,000, your loan account will be closed and your original FD will remain safe as it is without any loss.
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It is clear from this comparison that choosing Loan Against FD for short-term needs saves you from potential loss of thousands of rupees.
Choosing the right route between the two options depends on the time frame you require and your repayment capacity:
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Impact on credit score: No CIBIL score is required to take loan against FD, because your FD is already secured with the bank. Even if your credit score is bad, you can avail this loan without any hassles. Paying it on time strengthens your CIBIL score.
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Zero Processing Fee: Most banks do not charge any processing fee or pre-payment penalty for loans or overdrafts against FD. You can close the loan whenever you want without any extra charges.
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No tax hurdles: If you have made a 5 year tax saver FD (Section 80C), then as per the rules there is a lock-in of 5 years on it; It cannot be broken nor can a loan be given on it. The interest earned on normal FD is added to ‘Income from Other Sources’ and is taxable as per your tax slab.
Nowadays there is no need to even go to the bank branch. If you have internet banking or mobile app (like SBI YONO, HDFC MyCards, ICICI iMobile), you can go to the ‘Loans/Overdraft against FD’ section and get the loan amount instantly transferred to your savings account against your FD in just a few clicks.
If the need is of short duration then instead of breaking the FD, taking a loan or overdraft against it proves to be the smartest and economical decision financially.