Why you lose so much when breaking bank FD

Relatively low risk and fixed returns - these are two big reasons why the fixed deposit (FD) takes up a prominent spot in the investment portfolios of many people. Another advantage of the FD is liquidity. Banks normally allow easy prematurely redemption of regular callable fixed deposits but often with a penalty.

This feature of the FD is useful for those who are in need of emergency funds, a situation that many are in today thanks to the fallout of the coronavirus pandemic.

Now, before you opt to prematurely redeem your FD investments, there are two things you should know.
1) How the bank calculates interest on the 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, Paisabazaar.com says, "In case of premature withdrawal of fixed deposit, the effective interest rate will be lower of the booked rate (i.e., the interest rate at which FD account was opened) or the card rate for the period for which the FD remained with the bank as on the date of the opening of fixed deposit account."

If booked rate is higher than card rate: Let us say you opened an FD account with a bank for Rs 1 lakh with a tenure of one year. At the time of investing, the prevailing interest rate for a one-year FD was 7 per cent. Then after six months you break the FD to meet a financial exigency. The interest rate for a six-month FD back then was 6.25 per cent. Here, the interest rate that will be payable to you will be the rate that was applicable for a six-month FD at the time you opened the FD because the six month rate (card rate) was lower than the rate for 1 year (booked rate) at that time. The bank will calculate the interest at the rate of 6.25 per cent (instead of 7 per cent; lower by 0.75 per cent) on the principal amount of Rs 1 lakh, and pay you accordingly.

Payment in case of premature withdrawal of FD*

Principal amount	Rs 1 lakh
Booked interest rate on one-year FD	7 per cent per annum
Maturity amount after one year	Rs 1,07,186
Interest rate (card rate) on 6-month FD (at the time of opening of FD account)	6.25 per cent per annum
Amount due at premature withdrawal of FD	Rs 1,06,398

*Assuming quarterly compounding; no penalty charges

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

Let us say you opened an FD account with a one year tenure at an interest rate of 6.25 per cent per annum. You then decide to prematurely withdraw after 91 days. As per the interest rate card at the time of opening of FD account, the prevailing interest rate was 6.50 per cent for an FD with a tenure of 91 days. In this case, the bank will calculate interest to be paid on the FD being prematurely withdrawn at the rate of 6.25 per cent.

In both scenarios, once the effective interest rate is arrived at in case of premature withdrawal of FD, the bank will levy a penalty if applicable.

Penalty on premature withdrawal of FD
Banks often charge a penalty on closing/prematurely withdrawing fixed deposits before completion of the booked tenure.

Kukreja says that the penal interest rate can go up to1 per cent depending on the bank, the original tenure of the FD and the tenure for which the fixed deposit actually remained with the bank. Premature withdrawal penalty is subtracted from the effective rate of interest of the fixed deposit.

As per the State Bank of India (SBI) website, the following charges will be levied in case of premature withdrawal of FD:

For retail term deposits up to Rs 5 lakh, the penalty for premature withdrawal will be 0.50 per cent (all tenors).
For retail term deposits above Rs 5 lakh but below Rs 1 crore, the applicable penalty will be 1 per cent (all tenors).

HDFC Bank charges a penalty of 1 per cent on the applicable rate in case of premature withdrawal of FD, as per the bank's website.

We now go back to the example mentioned above. Let us say the person had booked a one-year FD of Rs 1 lakh with SBI at 7 per cent. Upon premature withdrawal after six months, the applicable interest rate will be 6.25 per cent (since the card rate is lower than the booked rate). Since SBI charges a premature withdrawal penalty of 0.50 per cent on FD amounts of less than Rs 5 lakh, the effective interest rate after deduction of the penalty will be 5.75 per cent (less than the original booked interest rate by 1.25 per cent). The amount to you will be Rs 1,05,875, calculated at 5.75 per cent in case of premature withdrawal.

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

Principal amount	Rs 1 lakh
Booked interest rate on one-year FD	7 per cent per annum
Maturity amount after one year	Rs 1,07,186
Interest rate on 6-month FD (at the time of opening of FD account)	6.25 per cent per annum
Penalty charges due to premature withdrawal	0.50 per cent
Effective Interest rate payable	5.75 per cent
Amount receivable due to premature withdrawal	Rs 1,05,875

*Assuming quarterly compounding

Do keep in mind that there can be instances where you will not be penalised for premature FD withdrawals. Kukreja says, "Some banks waive off the penal interest rate on fixed deposits of certain customer categories, for a specific tenure."

Some banks may not levy penalty in case of premature withdrawal of FD booked for a certain period. For instance, as per the HDFC Bank website, there is no penalty for premature withdrawal of FDs booked for a tenor of 7-14 days.

On the other hand, some banks will not pay interest if the FD is kept with the bank for less than a minimum period. For instance, as per the SBI website, the bank does not pay interest on FD for a tenure of less than 7 days.

What should you do?
Prematurely withdrawing your FD can cost you thanks to the penalty and if there is a reduction in effective interest rate. Therefore check the bank's terms and conditions for premature withdrawal at the time of putting the FD.

Before taking a call on whether to break your FD or not, do the math. Calculate how much you will lose out due to the penalty, if applicable and the reduction (if any) in effective interest rate on the premature withdrawal of the FD.