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What are Fixed Deposits and How Do They Work

Updated on: 24 Jan 2024 | 10 mins read

Fixed Deposits (FDs) are a natural choice for investors exploring investment options that involve minimal risk and offer assured returns. If you have a lump sum surplus to invest, depositing it to an FD account instead of a savings account would be wise because the returns offered by FDs are higher than those offered by a savings account.

You can open an FD account with a bank, a deposit-taking Non-Banking Financial Company (NBFC) or at a post office. While the minimum investment amount varies across financial institutions, there is no limit on the maximum investment.

But have you wondered how a fixed deposit works? How do banks benefit from your FD account? In this article, we decode these underlying concepts while introducing you to the different types of FDs.

What is Fixed Deposit

Fixed Deposit (FD) is an investment scheme in which you can invest a lump sum amount for a specific tenure for a fixed interest rate. Banks, Non-Banking Financial Companies (NBFCs), and post offices offer FD schemes. The interest rate remains unchanged throughout the tenure, giving you assured returns. The interest rate depends upon the investment amount and tenure, varying from bank to bank.

Moreover, senior citizens are offered higher interest rates on their investments in an FD scheme. Also, FDs placed with a  bank are insured by DICGC up to INR 5,00,000. Unlike mutual funds, investments in an FD scheme fall under the almost-zero risk category as they offer assured returns with negligible risk upto INR 5 lacs per bank.

 

You can open multiple FD accounts in banks and NBFCs. You can also close an FD account if you need funds in a financial emergency. Many FD schemes allow you to withdraw your investment before the maturity date; however, you will have to pay a penalty.

Some FD schemes (with a tenure of five years) also offer tax deductions on investments up to Rs. 1,50,000 as per Section 80C of the Income Tax Act, 1961. Furthermore, you can avail of loans by keeping your FD as collateral and enjoy a lower interest rate.

Features of Fixed Deposit

The features of a fixed deposit are as follows:

  1. Fixed Interest Rate: One of the critical features of an FD is that it offers a fixed interest rate for the entire investment duration. 
  2. Tenure: FDs have a fixed tenure ranging from a few months to several years. When opening an FD, you can choose a tenure that suits your investment goals.
  3. Minimum Investment Amount: Banks and financial institutions have a minimum investment amount for FDs. This can vary from bank to bank and can be as low as a few thousand rupees.
  4. Tax Implications: The interest earned on FDs is taxable as per the Income Tax Act. However, senior citizens can avail of higher interest rates and tax exemptions on the interest earned.
  5. Renewal Option: At the end of the tenure, you can renew the FD for another term or withdraw the investment.
  6. Loan against FD: In urgent need of funds, the investor can avail of a loan against FD. It can be upto 95% based on the Bank’s policy. 
  7. Nomination Facility: FDs allow you to nominate a person who will receive the investment and interest in case of your untimely demise.

How Does a Fixed Deposit Work?

Fixed Deposits (FDs) are deposits for a predetermined period chosen by the investor at a fixed interest rate. When you invest in FDs, your money gets locked for the selected investment tenure, which can range between seven days and ten years. Now, let us look at how a fixed deposit account works.

Suppose you chose a two-year tenure for a bank deposit of Rs. 50,000. With the assurance that your investment is locked for the specified period, banks will utilise it for lending to borrowers – individuals or corporates. Banks function under an asset-liability management system. Your deposits are liabilities for banks, and the loans provided are assets. So, in opening an FD account, you are building liabilities for the bank.

 

The interest rates offered on FD vary across institutions and are based on your investment tenure and amount. Each financial institution fixes its interest rates depending on the repo rate changes, as announced by the Reserve Bank of India (RBI), from time to time. The vital point to note is that during your FD tenure, even if interest rates fluctuate, you will be entitled to the rates promised when opening the account.

However, the scenario changes when you withdraw prematurely. In this instance, you need to pay a penalty or withdraw at a lower interest rate than the predetermined rate.

So, banks utilise your funds for a fixed tenure, and in return, they pay you a predetermined interest on the deposit.

Types of Fixed Deposits

Now, let’s look at the various types of FDs.

  • Standard Fixed Deposits
    A standard FD is an FD scheme in which you can invest a lump sum amount for a fixed tenure at a fixed interest rate. This interest rate set by the bank remains the same throughout the predetermined tenor and is typically higher than a savings bank account. This tenure may vary from seven days to 10 years, depending on the financial institution where your account is being opened.
  • Corporate Fixed Deposits
    Investors can make deposits with corporates to yield higher returns than Standard FDs.Generally, financial institutions and deposit-taking NBFCs (Non-Banking Financial Companies) offer such deposits. These deposits are risky and unsecured, i.e. if the company defaults, investors might not be able to recover the amount.
  • Tax-saving Fixed Deposits
    A tax-saving FD is an FD scheme that allows you to save taxes on the gains from your deposits. As per Section 80C of the Income Tax Act, 1961, you can avail of tax deductions on investments up to Rs. 1,50,000 per year. However, in this case, the lock-in period would be five years.
  • Cumulative Fixed Deposits
    Under this scheme, periodic compounding will accumulate your interests until maturity.  The interest earned every year is added to your principal amount and paid upon maturity. Generally, interest is compounded quarterly in case of cumulative FD.
  • Non-cumulative Fixed Deposits
    In a non-cumulative FD, the interest income is paid at specific intervals – monthly, half-yearly, quarterly or yearly.
  • Senior Citizen Fixed Deposits
    People above the age of 60 years are eligible to open a senior citizen FD account. The interest rate in this FD scheme is higher by 0.5-0.75% than that provided by standard FD schemes. A senior citizen can claim savings and fixed deposits interest deduction restricted to Rs 50,000 under section 80 TTB; the provision is exclusively for senior citizens.
  • Flexi Fixed Deposits
    A Flexi FD is formed by combining a fixed deposit and a demand deposit. It allows investors to enjoy the liquidity of savings or current accounts and the higher interest rates offered by an FD account. Here, you link an FD account with a savings account. 

After making an initial deposit in an FD account, you set the balance limit for your savings account. Flexi deposits have access to the auto sweep feature; if the balance in the savings account exceeds the limit, the excess amount can be transferred to the FD account automatically.

How to Invest in Fixed Deposits

You can invest in fixed deposits both online and offline. The process is as follows:

 

Online

  1. Log in using the net banking facility from the bank’s official website. You can also log in through the bank’s official app. The same applies to the chosen NBFC or post office.
  2. Search for the “Open Fixed Deposit” tab.
  3. Fill out the necessary details, including your account's investment amount, tenure, and nominee.
  4. Then, transfer the investment amount and complete the application process.

 

Offline

  1. Visit the nearest branch of the bank, NBFC, or the post office where you already have a savings account or wish to open an FD account.
  2. Request an FD application form and complete all the necessary details, including your account's investment amount, tenure, and nominee.
  3. Submit the required documents –address proof, identity proof and any other document the institution deems necessary.
  4. Submit the investment amount in cash or by cheque. If you already have a savings account, the amount will be transferred from the savings account to the FD account.
  5. The application will be processed, and you will receive a fixed deposit certificate within a day or two.

Tax Implication of Fixed Deposits

  • Tax Benefits: Banks and post offices provide 5-year fixed deposit accounts eligible for tax deductions under Section 80C, up to ₹5 lakhs.
  • Taxation on Interest: For individuals below 60, interest earned on fixed deposits is taxable at applicable slab rates.
  • Senior Citizen Benefits: Senior citizens can enjoy tax-free interest income up to ₹50,000 under Section 80TTB.

Final thoughts

FD is one of the safest investment instruments you will come across. However, you need to know more than how a fixed deposit works to help you decide; you should also consider parameters like interest rate, tenure, maturity amount, and terms and conditions related to premature withdrawal before investing in a scheme.

FAQs

Do banks provide a facility to open an FD account online?

Yes, you can open an FD account online with most banks. This facility can be availed through the bank’s internet banking portal or application. India Post also offers online account opening facilities for FDs via its internet banking service.

Can I change the tenure for my FD investment?

The investment tenure for an FD account remains fixed. You cannot change it once you open an account. However, you may be allowed to withdraw prematurely after paying the penalty.

Who can open an FD account?

The following individuals and organisations are eligible to open an FD account:

  • Indian residents
  • Non-resident of India (NRI)
  • Senior citizens
  • Minors
  • Sole proprietorship or partnership firms and companies
  • Family trusts, societies, and clubs.

Can I save tax by investing in an FD scheme?

Yes, you can invest in tax-saving FD schemes. This scheme allows you to avail tax deductions on investments up to Rs. 1,50,000 per year, as per Section 80C of the IT Act. Generally, these FD schemes come with a lock-in period of five years.

Can I link my FD account with my savings account?

Yes, you can link your FD account with a savings account. For Flexi FD and sweep-in FD, you can set a limit on the balance in your savings account. The excess amount can be transferred to your FD account if your balance exceeds the limit.

What is the minimum amount required to open an FD?

You can open an FD for an amount as low as Rs. 100.

Can I get a loan against FD?

If you face an emergency, like a medical crisis, a loss of job, or any other financial obligation, you can avail of a loan against FD and get the funds you need.

Are Fixed deposit investments safe?

FD investment in India is secured. No market fluctuation can affect it. The interest rate for an FD scheme also remains fixed during a given period until it reaches its maturity.

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