We keep getting easy free advice a lot about fixed income instrument from our family, friends, relatives and neighbours etc. Indian investors are happy to stay with comfortable investing their savings in safer and getting fixed percentage investment avenues such as bank fixed deposits (FDs) despite rising in the cost of living and increasing demands of our family members. They are always making the choice of their investment is in jumping for a higher rate of interest, without taking into consideration the effective after tax return and to beat the inflation bug. However, in the last couple of months inflation is rapidly falling which is first indicating to plunge into fixed deposits, especially in uncertain times such as the present. The rate of return on FDs is ranging from 8.0% – 9.0% for 1 year deposits at present, but now it appears that the interest rates on such FDs are now expected to start their downward move, thereby yielding investors with low returns. Because, when inflation was high, interest rates were also high, we got 10 or even 12 per cent from different kinds of deposits. Ironically, these returns were still low in real terms as it creates an illusion, false impression, that you were earning a lot of money. In reality, getting 10 per cent when inflation was 9 per cent is no different from getting 5 per cent while inflation is 4 percent. Thus, paradoxically, higher inflation makes higher interest rates to curb the liquidity into the debt market.

Evaluate

While putting the money into fixed deposits, a prudent investor should always compare the break-even or effective return on his investment to fulfill his dreams and that of his family. A key component of this entire exercise would be the fixed deposit (FD) investments that would require the investor should take an evolution call on how they would actually go about the whole process.

Compound Interest at Higher Frequencies

You see, investment avenues such as corporate deposits, tax-free bonds, dynamic bond funds etc., have caught investor attention, they offer compound interest of 12.5% p.a. (compounded annually) and other of 12% p.a. (compounded monthly). The ordinary investors are likely to be obviously tempted with the 12.5% scheme at the first sight. However, if they bother to make elaborate calculations, they will find that the deposit of Rs 1 lakh will get mature to a sum of Rs 1,80,240 at the end of five years under the 12.5% scheme (interest compounded annually) whereas they will get a sum of Rs 1,81,670 under the same scenario in 12% scheme (interest compounded monthly). It is so evident that the investor stands to gain a clear sum of Rs 1,430 even though he opts for an apparently lower yield of 0.5%. Hence, it is noteworthy that the effective yield of compound interest at higher frequencies is comparatively more than that at lower frequencies. While choosing the rate of interest, it is imperative to know the fact that the effective high yield of interest depends upon number of frequencies such as compounded annually, half-yearly, quarterly or even monthly. ‘Higher the frequency of compounding, the greater the yield’. This mantra would make work wonders with your investment.

For an easy comparison of effective equivalent annual rates of interest compounded at higher frequencies, the following table entitled ‘Effective Rate of Interest Compounded at Higher Frequencies’ has been complied.

Interest % Annually Half Yearly Quarterly Bi-Monthly Monthly
6.0 6.00 6.09 6.14 6.15 6.17
7.0 7.00 7.12 7.19 7.21 7.23
8.0 8.00 8.16 8.24 8.27 8.30
9.0 9.00 9.20 9.31 9.34 9.38
10.0 10.00 10.25 10.38 10.43 10.47
11.0 11.00 11.30 11.46 11.52 11.57
12.0 12.00 12.36 12.55 12.62 12.68
12.5 12.50 12.89 13.10 13.17 13.24

This above table explains how savvy investor would stand to gain even if he were to select the 12% (monthly compounding) scheme as compared to the 12.5% (annual compounding) scheme, since the effective equivalent rate of the former would in fact work out to 12.68%.

Pre-Tax and After-Tax Returns

Similarly, it is not uncommon to see an ordinary investor in a high tax slab who is unable to appreciate the worth of a tax-free investment, break-even rate of interest or the pre-tax return of which is in fact much higher than the seemingly low rate of interest attached to the investment. You should prepare to accept the fact that if your income is liable to income-tax in the tax-slab of 30.9%, you should be much better off with a 8.70% tax-free return as compared to a 10% return while supposing your investment of Rs1 lakh in PPF would fetch you earn an interest of Rs8,700 @ 8.70% p.a. since you do not have to pay any income-tax thereon, the entire Rs8,700 remains with you. If this amount is invested in a deposit earning taxable interest @ 10% p.a., you would undoubtedly earn a higher return of Rs10,000 on the same investment. But considering the fact that would have to pay income tax of Rs3,090 @ 30.9% on the interest earned of Rs10,000, you will be ultimately left with a saving of only Rs6,910.

While considering the fact of ‘evaluating your effective yield’, in the above case your tax-free return of 8.70% works out to an actual break-even pre tax return of 12.59% which would be equivalent to an after-tax return of 8.70% applying your marginal tax rate of 30.9%. This naturally compares more favorably with the given choice of 10%. To put it with other way round, your taxable return of 10% works out to an effective after-tax return of 6.91% as outline above, which still cannot match the alternative of the 10% return which is not subject to income tax.

For example, the break-even rate of interest before tax on a tax-free return of 8.70% at different income-tax slabs in the case of an individual for Assessment Year 2015-16 would be as under:

Income Range Rate of Tax including EC+SC Break-even rate of interest before tax
Up to Rs 2.50 Lakhs Nil 8.70%
2.50 lakhs – 5 lakhs 10.3% 9.70%
5 lakhs – 10 lakhs 20.6% 10.96%
10 lakhs- 1 crore 30.9% 12.59%
1 crore and above 33.99% 13.19%

Similarly, the effective rate of interest after tax on a taxable return of 10%, at different income-tax slabs in the case of an individual for Assessment Year 2015-16 would be as under:

Income Range Rate of Tax including EC+SC Effective rate of interest after-tax
Up to Rs 2.50 Lakhs Nil 10.00%
2.50 lakhs – 5 lakhs 10.3% 8.97%
5 lakhs – 10 lakhs 20.6% 7.94%
10 lakhs- 1 crore 30.9% 6.91%
1 crore and above 33.99% 6.60%

 It must also be borne in mind that such comparison of pre-tax or after tax returns is bound to vary keeping in view the marginal tax rate of the concerned investor.

Counter the Inflation

As you see that the inflation situation eases, interest rates are likely to fall in coming months. However, while investing in a fixed deposit offering interest at the rate of 9.00% p.a. in a current scenario where the average inflation rate is say 8.00% p.a. In such a case of you haven’t yielded a very fruitful return which can counter inflation since you are effectively earning only 1.00% (pre-tax) as the real rate of return. If we consider post-tax return with marginal rate of taxation, the real rate of return always turns to be in negative. In such case, it is vital to recognize that you may not be able to meet your financial goals. To counter the inflation, it is pertinent to know your risk profile, investment horizon and sensitivity of your financial goal which would decide to have exposure to a mix of asset classes in the portfolio and investment instruments therein, so as to clock better post-tax real rate of return on your portfolio. Usually a period of two to three years is taken for short-term view; one can go for bank fixed deposits after considering all real facts as outline above, otherwise you should ideally have some exposure to equities which offer an opportunity to earn high returns, which comes with quite safe in the long run say 7-15 years. Remember always, while investing all money in bank fixed deposits and any debt instrument, your investments are being secured but putting all financial goals in risk. The Choice is yours…

 

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Suresh Kumar Narula

SEBI Investment Advisor, Founder & Principal Financial Planner at Prudent Financial Planners
Suresh K Narula is founder and Principal Financial Planner at Prudent Financial Planners. He has earned the professional CERITIFIED FINANCIAL PLANNER and got registered with SEBI as Investment Advisor. He writes on personal and financial planning articles and got published in Dainik Bhaskar, Business Bhaskar and The Financial Planner's Guild, India. He is also a member of Financial Planner's Guild India ( An association of practicing SEBI registered Investment advisers) to create awareness about Financial Planning in general public, promote professional excellence and ensure high quality practice standards. Suresh received his an M.com from Himachal Pardesh University and an MFC from Punjab University, Chandigarh. He can be reached at info@prudentfp.in
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