One has surely heard of the power of compounding and the benefits it provides. The story of the king and his wise minister comes to mind when one speaks of compounding. The king greatly pleased with his ministers wit asks him for anything he wants. The minister asks for grains of wheat to fill up a chessboard. Please double the grains compared to the earlier square he says. One grain for the first square, two for the second, four for the third and so on. There is insufficient wheat in the whole of the kingdom to fill the chessboard and the minister gains a kingdom. Time for one to benefit from the power of compounding?
What is a Recurring Deposit?
A recurring deposit is similar to a systematic investment plan of a mutual fund.A fixed installment is made every month and interest is paid by the bank on these amounts. Banks insist on a savings bank account to be opened with it as monthly installments will be routed through this account. A fixed sum of money is deducted every month from ones savings bank account or even a current account. At the end of the tenure of the recurring deposit the amount invested as well as the interest portion accrued is paid back to the investor.
What are the Salient Features of a Recurring Deposit?
- A recurring deposit can be opened at a public sector bank with a minimum amount of as less as INR 100.Private sector banks generally have a minimum range of INR 500-1000. A post office opens these accounts for an amount as less as INR 10.Certain banks have no upper limits on the sum invested whereas some banks have an upper limit of INR 15 Lakhs.
- The minimum tenure of a recurring deposit is for a period of six months and a maximum tenure of 10 years.
- If the date of making the payment on the monthly installments is the first of a particular month say October then the installments will be regularly deducted on the first of each month. A passbook is provided recording all these transactions.
- The recurring deposit can be in ones name or opened jointly with a family member or even with a minor.
- The recurring deposit has a lock in period of one month .If the account is closed before this no interest is paid .However the principal amount is returned.
- A penal interest of 1-2% in case of premature withdrawal .is charged on the deposit.
- The account is closed if one misses the payment of four to six installments. The account can be revived by paying the outstanding amounts within a month from the last default.
- A loan or an overdraft facility can be availed against 90% of the balance in the recurring deposit.
- NRI’s cannot open recurring deposits at post offices but can set up these accounts under their NRE account with banks.
What is the Interest Rate Payable on a Recurring Deposit?
Both public sector as well as the private sector banks offer interest on the recurring deposit of different tenures. The interest rates are in the range of 8-9% for both the private sector banks as well as the public sector for a tenure ranging from a year up to 5 years Banks usually compound interest quarterly.
How Does Compounding Work in a Recurring Deposit?
Mr Dinesh opens a recurring deposit with a private sector bank for a period or tenure of 2 years. He invests INR 25000 per month regularly during this period. The interest rate offered is 8.5% for the two year tenure. What is the amount accrued after this period?
The formula for compounding is as follows :
P = Initial investment.
r = annual nominal interest rate
n = number of times the interest is compounded per year.( In case of quarterly compounding n=4)
t = number of years.
A = final amount.
Table showing the calculations of the accrued amount in a recurring deposit after two years
- One can understand from this example that Mr Dinesh has invested INR 6 Lakhs over a period of two years which becomes INR 6.55 Lakhs at the end of the tenure of two years.
What are the Tax Implications of a Recurring Deposit?
- Banks do not deduct TDS (Tax Deducted At Source) on recurring deposits .The interest portion is taxable and will be added to ones income and taxed as per the relevant slab.
What are the Benefits of Opening a Recurring Deposit?
- One can get the same rate of interest even on the final installment of the recurring deposit even if the rates are lower at that point of time. A recurring deposit allows one to invest a pre determined amount for a fixed tenure and interest rate.
- In a fixed deposit one would generally invest larger sums of money. Small amounts of INR 10-100 are sufficient to invest in a recurring deposit.
- Senior citizens get an additional 0.5% higher interest than other citizens.
- Some banks have even waived off the penalty on premature withdrawal.
What are the Pitfalls of a Recurring Deposit?
- Failure to make the necessary contributions on time may result in the closure of the recurring deposit.
- Once decided and fixed the tenure and the monthly contribution cannot be changed.
- Post offices offer partial withdrawals after a year of holding the recurring deposit. However banks do not offer this facility.
- One needs to fix the tenure and the payment amounts in a precise manner in order to avoid a default. Setting the payment amounts too high is one of the most common causes of a default in the recurring deposit.
- Frequent defaults and not making the payments on time may lead to a closure of the account.
- One major drawback is one cannot opt for partial payment mainly payments cannot be broken into installments. If a sum of INR 1000 has to be deposited payments have to be made as a single payment. If one deposits an additional amount above the decided amount no interest is paid on the additional amount.
I would like to end this article stating that one should add a recurring deposit to the portfolio of investments. This can add the power of compounding to the invested amount. Never underestimate the power of small sums on money. The mighty ocean is a collection of little drops of water.
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