How interest on bank FD is calculated in case of premature withdrawal

Relatively low risk and constant returns: These are two main reasons why the fixed deposit (FD) is prominently in many people's portfolios. Another advantage of FD is liquidity. Banks generally allow easy early recovery of regular callable fixed deposits but often with a penalty.

This feature of FD is useful for those who need emergency funds, a situation that many live today due to the consequences of a coronavirus pandemic.

Now, before choosing to prematurely redeem your FD investment, there are two things you need to know.

1) How does the bank calculate the interest in FD to arrive at the amount refunded?

2) And how the levy of penalty on premature encashment affects the amount that is paid to you.

How the interest is calculated

Naveen Kukreja, CEO and co-founder of Paisabazaar.com says: “In case of early withdrawal of the fixed deposit, the effective interest rate will be lower than the reserved price (ie the interest rate at which the FD account was opened) or the price of the card for the period in which the CFO remained with the bank on the opening date of the fixed deposit account.

If the reserved price is higher than the card price: Suppose you opened an FD account with a bank for 1 rupee to Korea for one year. At the time of investment, the one-year FD interest rate was 7 percent. Then, after six months, the FD broke out of the financial imperative. The six-month FD interest rate at that time was 6.25%. Here, the interest rate it will pay you will be the rate that was valid for FD for six months at the time the FD was opened because the six-month price (card price) was lower than the one-year price (the rate was reserved) at that time. The bank will charge interest at 6.25 percent (instead of 7 percent; 0.75 percent less) on the principal amount of Rs 1 lakh and will pay you accordingly. 

Payment in case of premature withdrawal of FD*

If the booked rate is lower than the card price: In this scenario, the refund will be calculated using the reserved interest rate in case of early withdrawal. 

Let's say you opened an FD account for one year at an interest rate of 6.25 percent per year. Then it was decided to retire prematurely after 91 days. According to the interest rate card at the time of opening the FD account, the prevailing interest rate was 6.50 percent for the FD with a 91-day period. In this case, the bank will calculate the interest payable on the FD that is withdrawn prematurely at a rate of 6.25 percent.

In both scenarios, once the effective interest rate is reached in the event of an early withdrawal from the FD, the bank will impose a penalty if that is possible.

Penalty on premature withdrawal of FD.

Banks often impose a fine for closing / withdrawing fixed deposits prematurely before completing the reserve period.

Kukreja says the penalty rate can increase to 1 percent depending on the bank, the original owner of the FD, and how long the deposit already held have been in the bank. The early withdrawal penalty is deducted from the effective interest rate on the fixed deposit. 

According to the website of the State Bank of India (SBI), the following fees will be charged in  case of premature withdrawal of FD:

For retail term deposits of up to Rs 5 lakh, the penalty for early withdrawal will be 0.50% (all tenors).

• For retail term deposits above Rs 5 lakh but below Rs. 1 crore, the applicable penalty will be 1 percent (all tenors).

HDFC Bank imposes a 1 percent penalty on the applicable rate in the event of early withdrawal of FD, according to the bank's website.

Now we return to the previous example. Suppose a person has reserved a 1-year FD of Rs 1 with SBI at 7 percent. On early withdrawal after six months, the applied interest rate will be 6.25% (because the price of the card is lower than the reserved price). Since the OSE imposes an early withdrawal penalty of 0.50 percent in amounts of FD less than 5 lakh, the effective interest rate after the deduction of the penalty will be 5.75 percent (less than the original interest recorded at 1.25 percent). The amount for you would be Rs 1.05,875, calculated by 5.75 percent in case of early withdrawal.

Payment in case of premature withdrawal of FD* with penal charges

*Assuming quarterly compounding

Please note that there may be cases where early withdrawals of federal funds will not be penalized. Kukreja says: "Some banks waive the fixed deposit penalty interest rate for certain categories of customers, for a specific period."

Some banks may not impose a fine in case of early withdrawal of FD withheld for a specific period. For example, according to the HDFC Bank website, there is no penalty for the early withdrawal of foreign securities held for 7-14 days.

On the other hand, some banks will not pay interest if the FD remains with the bank for less than the minimum period. For example, according to the SBI website, the bank does not pay interest in FD for less than 7 days. 

What should you do?

It may cost you to withdraw your FD prematurely thanks to the penalty and if there is a decrease in the effective interest rate. Therefore, please review the bank's terms and conditions for early withdrawal when setting up FD.

Before making a call about whether you should break your FD or not, do the math. Calculate the amount of loss you will lose due to the penalty if any, and lower the effective interest rate on the premature withdrawal of the FD.

Source: Economics Times

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