A fixed deposit investment provides a guaranteed return for money saved into an account for a set period of time. The term of a fixed deposit can vary depending on the option selected by the investor. In South Africa, fixed deposit accounts are available for periods ranging from 3 months to 60 months.
The main issue with fixed deposit accounts is that they offer fixed rates that can work in either direction, that is, for or against the investor at different time intervals. Fixed deposit rates fluctuate in relation to the repo rate and the lending rate. Banks and other financial institutions use the lending rate to calculate the fixed deposit rate at a specific time, usually the first week of the month if the repo rate has changed.
Newer fixed deposit investment opportunities that outperform your current fixed deposit earnings may arise. This occurs when a lower fixed deposit rate is offered and newer, better rates become available. Staying invested in a low-yield fixed deposit account can result in a loss of profits.
It may then be necessary to redeem a fixed deposit investment to avoid losing funds. However, there are costs associated with breaking a fixed deposit investment. As a result, one must be aware of the consequences of prematurely terminating a fixed deposit account. The cost of prematurely terminating a fixed deposit account is discussed in the section that follows.
What happens when you break a fixed deposit investment prematurely?
Breaking a fixed deposit investment is something that many people do, but banks and financial institutions are likely to charge a penalty for doing so. The penalty varies by a financial institution, with some charging a percentage and others charging a fixed amount. A penalty can range from 0.5% to 2% of the investment value, depending on the bank used to open a fixed deposit account.
Some fixed deposit accounts do not charge a penalty for early withdrawal. Instead, they give the client their principal investment as well as the total interest earned from the date of deposit to the date of withdrawal.
There are several reasons why an investor may prematurely close a fixed deposit account, the most common of which is an emergency. However, an investor may have better opportunities, which may lead to an early withdrawal from a fixed deposit account. A premature withdrawal from a fixed deposit investment may be for better opportunities in the FD market.
There are some things to think about before withdrawing money from a fixed deposit account to invest in another high-yielding fixed deposit account. The considerations that an investor should make before breaking a fixed deposit account to invest in a higher-yielding account are discussed below.
3 things to consider before breaking a fixed deposit account for a better one
1. Calculate the opportunity cost of breaking the current fixed deposit account
There are two costs to consider before prematurely withdrawing from a current fixed deposit account. The first cost to consider is the penalty for early withdrawal from a fixed deposit account. The potential interest earned from the date to maturity is the second cost to consider.
A penalty is likely to be charged in the months before the fixed deposit account matures. If your account accumulates interest per month, year, or day, calculate the penalty using the days, years, or months remaining.
For example, an investment of R1.000 is locked into a 5-year fixed deposit account with an investor withdrawing after 4.5 years before maturity. This means that the penalty period will be 6 months. If interest is calculated annually, the penalty will be for 0.5 years.
The penalty for 6 months on an R1,000.00 investment in an FD paying 5% per month is R24.40. This means that the investor will be charged R24.40 for early withdrawal. The potential interest cost of breaking such a fixed deposit account is R55.24.
When withdrawing from this fixed deposit investment after 4.5 years in an account paying 5% interest per year, a total of R1,221.04 can be withdrawn from a potential withdrawal of R1,276.28 at maturity
2. Calculate earnings of the fixed deposit on the offer
The next step in deciding whether to keep or break a fixed deposit is to calculate the potential earnings of a new fixed deposit. This assumes that you will invest in the fixed deposit account until the current fixed deposit account matures.
If you find a fixed deposit account that pays an interest rate of 7.96% per year, which is more than the former FD of 5% per year, the new earnings will be calculated as follows:
- Principal R1221.04
- Interest rate 7.96% pa
- Number of years 0.5
The new value of the investment will be R1,269.64.
3. Consolidate the difference
The final step is to determine which option is superior. This step will assist you in determining whether or not to prematurely terminate the current fixed deposit account. To accomplish this, the following calculations must be performed:
Profit/loss = new fixed deposit earnings – old fixed deposit earnings up to maturity date
Profit/loss =R1,269.64 – R1,276.28
Loss = – R6.61
Switching to a fixed deposit account with a yield of 7.96% will currently result in a loss. This is due to the penalty fee you paid and the 6-month investment period in the new fixed deposit account. If a longer period of investment is available, investing in a new fixed deposit account may make sense.
A fixed deposit account investment is the most straightforward and it is easy to calculate its future returns on a current or prospective account. Breaking up a fixed deposit account in favor of a new fixed deposit account may or may not result in higher returns. Although the returns on a new fixed deposit account may be higher than those on an old one, penalties may reduce the profitability of the new investment.