How to make bank fixed deposits work for you

It's that time of the year when most of us would be receiving salary hikes and bonuses. While few of us would have already planned for things to buy or invest into, a majority would still be unclear about what to do with their money. For the latter, the money would lay idle in their banks' savings account by default.

Though it will earn an interest of 3.5 per cent per annum, we think you deserve to earn more. Don't you?
So instead of keeping it in the savings account, there are many schemes / facilities offered by banks that can come handy during these times. For example normal bank fixed deposits schemes, flexible rate deposit schemes, and sweep-in / sweep-out facility.

Each of these options provide for higher interest rates compared to bank savings account and with the same degree of safety. Let's look at these options and choose the right mix so that your money starts earning more money for you.

Everyone knows about bank fixed deposit (FD) schemes. The tenure of deposit ranges from 7 days to 10 years. However, the suggestion here is not to go for FD of less than 3 months. This is because the rate of interest on such deposits is less than what is offered by savings account (3.5 per cent).

Please note that as per the Reserve Bank of India's, RBIs, new guideline, the rate of interest on savings account will be calculated on a daily basis.

So, if you want high liquidity for 3 to 4 months, then do not use the FD route. Your savings account will fetch you 3.5 per cent interest anyways.

The best way to invest in a FD is to book multiple FDs with varying maturities. If you need certain amount of money after 1 year, go for 1 year FD for that much amount. Depending on the future money requirements, other FDs with higher maturity of say 3 years, 5 years or 7 years can been booked accordingly.

By applying this simple strategy, you are meeting your liquidity requirements as well as earning higher return on a cumulative basis. And not to forget, you are not breaking any FDs to meet your requirements.

Words of caution: At the time of booking any FD, make sure you are selecting the correct interest payout option. If you want regular returns, go for quarterly or half-yearly payout options. Else, choose interest re-investment option (your interest payout will be re-invested to earn more money for you).

Another advantage of investing in fixed deposits with tenure of 5 years or more is that you can avail tax rebate on your annual salary for the current financial year. As per Section 80C of the Income Tax Act, you are eligible to get tax rebate on an investment of up to Rs 1 lakh in bank FDs of 5 year or more.

The Flexible Rate Deposit Scheme collects money from investors and invests in government bonds of various maturities. Since government bonds are traded in the market, the rate of interest is determined by the economies of demand and supply.

Here too, you can select various products with different maturities and earn variable rates of interest. This way you can build a portfolio of flexible FDs that will match your returns with what is prevailing in the market.

The objective of the scheme is to provide protection against interest rate volatility by offering deposits at flexible interest rates. Flexible rate schemes are a win-win product for both the depositor and the bank since the rates are directly linked to the market.

Another advantage of this scheme is that it acts as a hedge against inflation. Ideally, if inflation rises, your real return (actual return minus inflation) from normal FD declines. However, in case of flexible rate deposit scheme, the real return would remain unchanged. This is because RBI will raise interest rate to tackle inflation, which in turn will raise market interest rate, and hence your return from flexible FD will increase proportionate to inflation.

Many banks are nowadays offering such facilities. The Sweep-in / Sweep-out facility provides the benefits of both worlds -- the liquidity of savings account and the higher returns of FD.

This is how it works: Whenever your savings account balance crosses the average quarterly balance requirement, the excess amount gets automatically swept into a flexible fixed deposit. Thus earning you a higher return vis-a-vis bank savings account.

The best part is that your FD is not fixed. In case you want to withdraw more than the available average balance, the fixed deposit will be broken to the extent of the amount you require to meet your needs. Thus giving you the liquidity of a savings account.

This is basically good for those who are not sure about their liquidity needs in the short-medium term.

Summary

By choosing a judicious mix of bank products discussed above, you can make your money work for itself. After all you have earned your annual bonus through sheer hard work and pain! But bank FDs are just one of the options for you.

You should look to exploit other options like stocks, mutual funds, real estate, etc. Here we have just provided guidance on how to leverage banks' existing products to generate higher returns vis-a-vis bank savings account. The idea finally is to make you a smart wealth manager of your own money.

How to plan and achieve your financial goals

The nature of financial planning was discussed in the first article of this series and we had looked at the answer for 'what is financial planning'. In simple terms financial planning was stated as the process of meeting life goals expressed in monetary terms, through proper management of finances.

The process of identifying the goals and estimating the monetary value of the expenses (Life goals expressed in monetary terms) will require an understanding as to how the costs increase over time generally referred to as inflation. The first step is to therefore clearly identify the goals and put a value/cost to be incurred at the relevant time estimating the increase in the cost of the goals over the current value based on past trends.

If a person wants to save say for a goal to be achieved after 5 years which currently costs Rs1,00,000, s/he will have to envisage a cost of Rs 1,33,822 at the end of 5 years given a level inflation of 6 per cent per annum. The sum has been worked by utilising the compound interest formula i.e. A= P*(1+R) ^T where A is the sum payable at the end of the term T (5 years here), R is rate of inflation (6 per cent here) and P is the current cost (Rs 1,00,000 here).

If one looks at only having Rs 1,00,000 in say a saving account there will be a shortfall as saving returns are at 3.5 per cent per annum which is much below the inflation rate. It is therefore imperative to grow the savings to meet the cost at the material time in future.

Financial planning therefore helps one to focus on the cost estimation in a rational manner which in turn can help in properly assessing the amount required to be saved periodically. Let us see the validity of this statement through an example.

Assume I require Rs 1,00,000 at the end of 5 years and I can earn, say 12 per cent, per annum or 1 per cent per month on my investment. How much per month I will have to save can be calculated using a calculator or an excel sheet function as Rs 1,225. We can also calculate the amount using the annuity equation as under:

A = 1,00,000/ [ ((1+1 per cent) ^60) 1 /1 per cent]

In other words we can see that to save an amount of Rs 1,00,000 we have to earmark Rs 1,225 per month assuming that the investments earn 1 per cent per month. The contributions made by us will total to Rs 73,000 (60*1,225) and when regularly invested will yield a total of Rs 1,00,000.

If we assume that the cost of Rs 1,00,000 has been estimated in a rational manner and the return expectation are estimated in a rational manner then we can see the truth in the above statement as without a planning perspective it would have been difficult to undertake estimation of cost and also the accumulation of resources.

Further, we can also see that planning perspective helps us in looking at avenues available in a manner suited to raise the required finances and in case of shortfall the alternative finance resources can be also thought. The financial planning can bring in focus the need to systematically put aside sums as savings to meet future goals.

The resource raising not only depends on systematic savings but also a perspective of saving for long term increases the accumulated value by enabling the person to harness the power of compounding. That is the income earned on investment also reaps the benefit of reinvestment when the investments are held for a longer period.

Let us look at this through an example. Amit & Balu (both 35-years old) are two friends who understand the need for savings to meet their post retirement expenses by building a corpus of Rs 45,00,000 to be available when they reach the age of 60.

Amit starts immediately by setting a sum of Rs 1,00,000 every year and investing the same in an asset yielding a return of 8 per cent per annum. This he undertakes for a period of 10 years till the age of 45 and thereafter allows the investments to grow at a compounded growth of 8 per cent per annum.

Balu who was not very enthusiastic early realises the need to focus on savings and decides to save from the age of 45 till 55 a sum of Rs 2,00,000 per year to grow at the rate of 8 per cent per annum and thereafter allows the corpus to grow at 8 per cent per annum till the age of 60.

The amount available with Amit at age 45 is Rs 14, 48,656, and Rs 31, 27,540 when he reaches 55. The amount available with Balu at age 55 is Rs 28, 97,312 and Rs 42, 57,103 at 60. The sums can be calculated using the compound interest formula and annuity equation discussed above.

This brings in focus the power of compounding and the need to start savings early & for long term as the money with Amit despite saving only Rs 10,00,000 against Rs 20,00,000 by Balu, is more at age 60. The results are presented in graphical mode below:

Amit's case study described in the part I has two goals: Car and education expenses. In case of car we have taken the current cost at Rs 5,35,000 expected to increase at 6 per cent per annum. Education is currently costing Rs 9,00,000 and is expected to increase at the rate of 9 per cent per annum.

The cost of car after 2 years will be Rs 6,00,000 and education after 8 years will be Rs 18,00,000.

Savings for purchase of car will be in bank deposits yielding 5.5 per cent per annum and for education expenses the savings will be the ratio of 70 per cent in equity and 30 per cent in debt yielding an average of 10.80 per cent per annum. The surplus available monthly is Rs 25,000 and the same is expected to grow at 2 per cent every year (Increase in income minus increase in expenditure) (10 per cent minus 8 per cent). If we calculate the amount required to be saved using the growing annuity equation then:

Future value cost = 1st year annuity*((1+ g) ^n (1+r) ^n) / (g-r) where r = rate of return on investment, g = growth rate of savings.

Using for car the figures of n = 24, r = 5.5 per cent/12, g = 2 per cent, FV = Rs 6,00,000, monthly savings = Rs 18,780 leaving approximately Rs 6,220 to be applied for other savings.

Similarly using the figures n = 72, g = 2 per cent, r = 10.80 per cent/12, FV = Rs 18,00,000, monthly savings = Rs 8,780 leaving approximately Rs 16,220 to be applied for other savings.

In Amit's case if we assume that the surplus of Rs 6,220 for the first two years and Rs 16,220 for next three years are invested in equity fund then together with current balance the equity assets will grow to approximately Rs 27,00,000 in 5 years of which Rs 15 lakh can be used towards margin money for a house costing Rs 30 lakh and the balance borrowed from a bank for a tenure of 15 years with approximate EMI of Rs 16,200 at an interest rate of 10.25 per cent per annum.

We can see that a financial planning perspective enables us to objectively view the goals as well as the resource-raising plan. Here we may also understand that the inflation, return rates on assets are dynamic and hence the plans have to be continuously monitored and periodically reviewed. Financial planning helps to keep these aspects in focus.

In the next part of the article next week we will look at the spectrum of investment opportunities and their return perspective. Estimating the right amount to be saved and for the right length of time, based on the requirements worked for the financial goals, is the first objective of financial planning.

In short, financial planning helps the investors to focus on their goal achievement.