Understanding Fixed Deposits

In a fixed deposit (FD), an investor makes a lump sum payment to a bank or non-banking financial firm (NBFC) for a predetermined period of time at a predetermined interest rate. With tenures ranging from a few months to several years, FDs are known for being safe and providing steady returns. FDs come in two varieties: cumulative and non-cumulative. An FD's interest can be compounded and paid out at maturity, or it can be paid out regularly.

What is a Non-Cumulative FD?

A non-cumulative FD does not compound interest until maturity; instead, it pays interest on a monthly, quarterly, half-yearly, or annual basis. For investors looking for consistent income, this makes it a good choice.

Key Features of Non-Cumulative FD:

• 1. Regular Interest Payouts: Investors receive interest on a regular basis, contingent on the frequency they choose.
• 2. Stable Income Source: Ideal for retirees and others who require steady cash flow.
• 3. Lower Compounded Returns: Because interest is disbursed rather than reinvested, the overall return is lower than cumulative FDs.
• 4. Flexible Tenure Options: There are options for both short- and long-term tenures.
• 5. Increased Liquidity: Investors can receive recurrent rewards without breaking the FD.

What is a Cumulative FD?

By reinvesting the interest, a cumulative FD enables it to compound over the period of the deposit. The principal and interest are paid out in one big sum at maturity.

Key Features of Cumulative FD:

• 1. Compounded Growth: As interest is applied to principal, more interest is earned.
• 2. Greater profits: Cumulative FDs produce larger total profits because interest builds up over time.
• 3. Ideal for Long-Term Investors: Fits for people who want to increase their money over time without receiving regular dividends.
• 4. Limited Liquidity: Prior to maturity, investors are unable to access the interest that has accumulated.
• 5. Tax Implications: Interest generated is subject to taxes at maturity, which could raise one's tax obligation for a particular fiscal year.

Liquidity Comparison: Non-Cumulative FD vs. Cumulative FD

One of the key differences between non-cumulative FD and cumulative FD is the liquidity they offer.

• Non-Cumulative FD: increases liquidity by giving investors regular interest payments, which makes it simpler to control monthly spending.
• Cumulative FD: is less appropriate for people who require consistent income because it offers less liquidity because all returns are fixed until maturity.

Flexibility Comparison: Non-Cumulative FD vs. Cumulative FD

Flexibility in an FD depends on tenure choices, interest payout frequency, and reinvestment options.

• Non-Cumulative FD: Offers more flexibility as investors can choose the frequency of interest payouts based on their financial needs.
• Cumulative FD: Less flexible, as the investor must wait until the end of the tenure to access interest income.

Suitability Based on Investor Profile

Who Should Choose Non-Cumulative FD?

Pensioners and retirees require a steady income to pay for their everyday needs.

• Individuals with Periodic Financial Obligations: Those who require stable returns to manage loan EMIs or living expenses.
• Investors looking for liquidity are those who wish to access returns on a regular basis without violating the FD.

For whom is Cumulative FD the best option?

• Long-Term Investors: People who want to increase their money over time.
• Individuals Without Immediate Financial Needs: Ideal for people who can keep their money locked for a longer amount of time.
• Tax planners: Individuals who prefer to postpone paying taxes on periodic distributions until maturity.

Taxation on Non-Cumulative and Cumulative FD

Both cumulative and non-cumulative FD earnings are subject to taxation. The tax treatment of interest earned differs slightly:

• 1. Non-Cumulative FD: Interest payouts are added to taxable income annually, potentially increasing tax liabilities each financial year.
• 2. Cumulative FD: Taxation is deferred until maturity, which might lead to a higher tax outgo in a single year, depending on tax slabs.
• 3. TDS (Tax Deducted at Source): If total interest earnings exceed ₹40,000 in a year (₹50,000 for senior citizens), banks and NBFCs deduct TDS at 10%.

Risk Factors and Considerations

While fixed deposits are generally considered safe investments, a few risks and considerations exist:

• Interest Rate Risk: Fixed interest rates may not always match inflation rates.
• Premature Withdrawal Penalty: Breaking an FD before maturity results in penalties and lower interest rates.
• Reinvestment Risk: At maturity, interest rates may be lower for reinvesting, affecting future returns.

How to Choose Between Non-Cumulative FD and Cumulative FD?

Investors should consider the following factors while choosing between non-cumulative FD and cumulative FD:

1. Financial Goals: Those needing regular income should opt for non-cumulative FD, while those focused on wealth accumulation should go for cumulative FD.

2. Liquidity Needs: If accessing returns at intervals is crucial, a non-cumulative FD is better suited.

3. Tax Considerations: Those aiming to defer tax liabilities may benefit from a cumulative FD.

4. Investment Tenure: Long-term investors benefit more from cumulative FD due to compounding benefits.

Conclusion

Both cumulative and non-cumulative FD meet distinct financial needs, and an individual's financial goals will determine which option is best for them. Non-cumulative FD is perfect for retirees and anyone who need consistent cash flow because it offers more liquidity and flexibility through periodic interest payouts. Conversely, cumulative FD is most appropriate for long-term investors looking to compound their capital. Investors can optimise the returns on their fixed deposit investments by making well-informed selections based on their financial objectives, tax implications, and liquidity requirements.