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Fixed Deposits: How FD laddering can maximise your investment benefits

Adhil Shetty
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Fixed deposits are one of the most popular investment instruments in India. The safety of funds, ease of investment, guaranteed returns and high liquidity are some of the factors that make them a very attractive option, especially for risk-averse investors. However, the repo rate has dropped by 135 basis points this year alone, which has led to a marginal decrease in the FD interest rates until now while the possibility of deposit rates going down further in the near future cannot be ruled out. Many investors are currently in a dilemma about whether to continue investing in FDs or to move to some other alternative instrument.

As such, it won't be wrong to say that fluctuation in deposit rates is one of the biggest concerns for FD investors. Their concerns are valid too. Let's suppose you invested in an FD at a 7% p.a. rate, but the interest rate increased to 7.5% after a few months. You might feel a bit disappointed thinking you could have earned 0.5% extra had you waited for a few months. On the contrary, let's suppose you were planning to invest when the FD rate was 7%, but then you anticipated a rate hike in the near future and thus, decided to wait for a few months. However, after a few months, the FD rate fell to 6.5% and you felt the pain of losing 0.5% interest income. As such, in either case, a hike or drop in FD rates impacted your investment decision which in all likelihood had a bearing on your investment strategy to meet your financial goals on time. Now let's discuss another common scenario. Assume you have invested in a 9% p.a. FD with a 5-year tenure, but on maturity, you realise that you'll get a rate of 7% p.a. if you reinvest the amount. As such, your earnings will go down by 2%.

So, if you're wondering how you can protect your FDs from interest rate fluctuations, there's a simple strategy that will help you maximise the investment benefits. It is called laddering. Read on as we discuss more on this.

What is FD Laddering?

Laddering is an investment technique under which one or more investment products with different maturity periods are used to create an investment loop. In the case of FD laddering, you can use different FD instruments with different maturities to invest your money. Instead of investing your entire corpus in a single FD, divide your fund equally and invest it in FDs with different maturities.

For example, suppose you want to invest Rs. 5 lakh. Under the FD laddering technique, you can break your corpus in five equal parts, i.e. into five FDs of Rs. 1 lakh each but with different maturities. Meaning, you can invest Rs 1 lakh each in a 1-year, 2-year, 3-year, 4-year and 5-year FD. And when your FDs mature, reinvest the fund. Let's say you reinvested each FD in a new 5-year FD, So when your 1-year FD matures, it will be reinvested for five more years and mature in the sixth year. The 2-year FD will mature in the seventh, the 3-year FD will mature in the eighth, and so on. In this example, you created an investment loop where one of your FDs matures every year and so that you will have ample liquidity to meet your financial requirements. You can devise your own laddering strategy based on your requirements.

More importantly, this would help in averaging out any interest rate fluctuation in the long term. Another benefit with laddering is that you don't need to disturb your entire investment corpus in the face of a financial emergency if your fund requirement can be addressed by liquidating a single FD. However, do note that any FD can easily be liquidated before maturity but after losing up to 1% of the interest income.

Why you should opt for FD laddering

At present, banks are offering 6-6.7% p.a. on FDs for different maturities. However, interest rates may go up in the future. And if you lock your entire fund for the long term and the interest rates do go up after a few years, you will lose the opportunity to earn better interest on your investment. However, using the FD laddering technique will allow you to earn interest close to the long-term average.

Do note that investing in different FDs doesn't mean you park all your money in the same bank. You can select different banks for this purpose based on offered interest rates, among other considerations. You can also consider limiting total deposits (both principal and interest) to Rs 1 lakh per bank. This would ensure your funds remain insured to that limit by the Deposit Insurance and Credit Guarantee Corporation (DICGC), a Reserve Bank of India (RBI) subsidiary, which protects depositors in case a bank fails.

The interest rate on FDs changes in sync with the prevailing inflation rate, so with the help of FD laddering, you can also lower the inflation risk on your investments. Distribution of investment across different FDs with different maturities reduces the holding period risk as well.

Final thoughts

You can benefit from a laddering strategy by either investing only in different FDs or spreading your investment to different instruments as mandated by your financial goals, risk appetite, income and liquidity requirements. This diversification of investments will help in meeting your financial goals by lowering the overall risk factor. Also, laddering as a technique will fortify your investments from the risk of interest rate fluctuations which would help you to achieve expected returns.

(The author is CEO,