Premature withdrawal method of FD dictates your loss

When a financial urgency arises, we usually have to break our savings to meet the emergency. The easiest option is to withdraw money prematurely from a fixed deposit. However, not many FD investors are aware of the two methods by which banks usually calculate the penalty if the money from the FD is withdrawn before the maturity date.

ET Wealth Online decodes the two methods of calculating the premature withdrawal FD penalty. Which penalty method is beneficial for FD investors?

Method 1: FD interest rate is reduced by a certain percentage
One of the most common methods of levying a penalty on premature withdrawal of an FD is the reduction of the interest rate by a certain percentage. For instance, your bank may give you 1% less on the FD interest rate if you go for a premature withdrawal from your FD.

Adhil Shetty, CEO of Bankbazaar.com, says, "Reduction in applicable FD interest rate by a certain percentage as per the bank's rule is one of the common methods to levy a penalty on premature withdrawal from FD. Usually, 1% or 0.50% is levied as a penalty on premature withdrawal from an FD by the banks. Suppose you have booked an FD for 18 months at 7.25%. However, due to some emergency, you break your FD after one year. The FD interest rate for one year, at the time of booking the FD, was 7%. The penalty applicable is 1%. Hence, the bank will pay you 6% interest at the time of breaking the FD before maturity."

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Method 2: A penalty is levied on the total amount
Some banks use another method of calculating the penalty at the time of premature withdrawal of the FD. Here, instead of levying a penalty on the interest rate, the penalty is levied on the total amount.

Shetty says, "Under this method, the bank first calculates the total accrued amount on the date the FD is being broken. The total accrued amount includes principal and interest. A certain percentage is levied as a penalty on the total accrued amount, and the balance is paid to the FD holder. Suppose you decide to break your FD before maturity. The bank levies 1% as a penalty on the total accrued amount. On the date, FD is being prematurely withdrawn, the total accrued amount is, say, Rs 50,000. The bank will levy a penalty of 1% on this amount, i.e., Rs 500 as a penalty. The balance amount will be paid to the investor."

Which saves more money for the FD investors?
Raj Khosla, Founder & MD, MyMoneyMantra.com, says, "Premature withdrawal penalties are levied to discourage investors from hasty termination of fixed deposits. A penalty only on the interest ensures a lower deduction, as there will be a marginal drop in the resultant return. On the contrary, a similar penalty levied on the principal and accrued interest will see a higher penalty amount."

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Let us understand this by taking an example.

Suppose you book an FD of Rs 1 lakh at 7% per annum for five years. Here we have taken two scenarios: a) Premature withdrawal happens before 6 months, and b) premature withdrawal happens after three years.

Premature withdrawal of FD happens before 6 months
Suppose the premature withdrawal of a five-year FD happens before 6 months of completion, say in the 5th month.

Penalty on applicable interest: According to the first method, the bank will first check the effective interest for 5 months of the FD on the date when the FD investment was made. Suppose this is 5% for a 5-month FD. A penal interest of 1% is applicable on the effective interest rate. Here, the bank will calculate the interest payable to you at 4% (5%-1%) on the principal amount.

Usually, banks do not offer compounding benefits on short-term FD tenure of 180 days or 6 months. In such a case, the FD payable amount is calculated on a simple interest basis. Here, it is assumed that the bank calculates the amount on a simple interest basis.

On the premature withdrawal of FD, the bank will pay you Rs 1,01,667.

Penalty on the total accrued amount: In the second method, the bank calculates the total accrued amount on the date the FD is prematurely withdrawn. Due to the FD's short-term nature, the bank will also calculate the accrued amount using simple interest. Remember, the total amount is calculated using the original contracted interest rate, 7% in this case.

Suppose the accrued amount is Rs 1,02,917. The bank applies a 1% penalty to this accrued amount, which comes out to Rs 1,029 (1% of Rs 1,02,917). This will be deducted from the total accrued amount of Rs 1,02,917, and the balance of Rs 1,01,888 will be paid to the FD investor.

In the first method, the individual loses Rs 221 as compared to the second method.

Premature withdrawal of FD happens after 3 years
In the second scenario, suppose the premature withdrawal of the FD happens after three years, say in 37 months. Here, the compounding benefit will be applicable in both methods as the tenure of the FD is more than 6 months, i.e., 37 months.

Penalty applicable to interest rate: Here, too, the bank will first check the effective interest rate for 37 months of FD on the date the FD was booked. Suppose this is 6.5% for 37 months. A penal interest of 1% is applicable on the effective interest rate. Here, the bank will calculate the interest payable to you at 5.5% (6.5%-1%) on the principal amount.

With an effective interest rate of 5.5%, the premature withdrawal is Rs 1,18,344, which will be paid to the FD investor.

Penalty on the total accrued amount: Here, the bank will calculate the total accrued amount on the date the FD is being prematurely withdrawn. The total accrued amount will be calculated on the original contracted rate, 7% in our example. The bank will also offer a compounding benefit as the FD has been held for 37 months.

Suppose the accrued amount is Rs 1,23,858. The bank will apply a 1% penalty on this accrued amount, which is Rs 1,239. This will be deducted from Rs 1,23,858, and the balance of Rs 1,22,620 will be paid to the FD investor.
Here, the individual loses Rs 4,275 in the first method.

As the tenure of FDs held before premature withdrawal increases, the penal calculation on the total accrued amount helps investors save more money compared to the penalty levied on the interest rate.

What you should do as an FD investor
As an FD investor, it is important for you to read the bank's terms and conditions while making an investment. The terms and conditions will help you understand how banks will calculate a penalty in case of premature withdrawal.

Khosla says, "The penalty on premature withdrawals could be higher for fixed deposits booked for longer tenures, while the penalty could be a few basis points lower for shorter tenures. Hence, check the terms and conditions while booking the FD."

However, the penalty could exceed 1% as well in certain cases. Khosla explains this with an example. For instance, the interest rate on a 1-year FD is 7.5% and the interest rate on a 6-month FD is 7% at the time of booking the FD. The interest will see a 150 basis point plunge if you're prematurely withdrawing an FD after 6 months. Therefore, the interest amount will be calculated at 6% (7%-1% penalty) for 6 months.

At times, banks may waive off premature withdrawal penalties in exceptional cases. Khosla says, "For instance, some banks don't levy a penalty on premature withdrawals on the FD if the gross proceeds are reinvested in a new fixed deposit. Banks, at their own discretion, can also waive off premature withdrawal penalties for senior and super senior citizens."

You should also check whether the FD you booked with the highest interest rate is callable or non-callable. Shetty says, "Premature withdrawal is applicable only to callable FDs. These deposits do not carry a lock-in period, offering flexibility in terms of access. On the other hand, non-callable FDs do not permit early withdrawal before the specified lock-in period. However, there are certain exceptions. According to Reserve Bank of India (RBI) guidelines, depositors may withdraw funds from non-callable FDs under exceptional circumstances such as bankruptcy, a court order, business liquidation, or in the event of the depositor's death. However, the penalty imposed for prematurely withdrawing a non-callable Fixed Deposit can be considerably higher."


(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com)