Recurring Deposits: An Incredibly Useful Product

My neighbour, an employee of a private firm came to me with a strange request last week. She wanted my advice on the type of bank account she should invest her money in so as to earn more than what she was earning in a savings account. Her ultimate goal was to save enough money to buy a two wheeler by the end of a year or two. Even before I could respond to her, she continued to explain that due to certain constraints she was in a position to invest amounts in the range of Rs 1000 to Rs 2500 only every month. This ruled out the possibility of her investing in a fixed deposit. From an earlier interaction with her I knew that she did not believe in investing in stocks or mutual funds. That basically left only her with only one option- Recurring deposit account with a bank.



Most banks in India both private as well as nationalised ones, offer recurring deposit account to customers. For people with needs similar to that of my neighbour opening a recurring deposit account is an excellent option. The purpose of this post is to provide complete details about Recurring deposit or RD accounts as it is popularly referred to.

What are Recurring Deposits?

Recurring Deposit is a special kind of Fixed Deposit. It is an ideal option for investors looking to deposit a fixed amount of money every month into a bank account and earn interest at the rate applicable to fixed deposits.

When you open an RD account with a bank you basically agree to deposit a specific amount (instalment) every month into the account on a particular date for a specific period of time. E.g you can open an RD account and agree to deposit Rs 2000 on the 10th of every month in that account for 2 years.

RD accounts can be opened by an individual singly, jointly or in the name of a minor by the guardian. Nomination facility is also available for these accounts.

Interest on RDs. The interest which you earn on this account is pre-determined and would normally be the same as the one applicable for fixed deposits. The rate of interest and the maturity value is always advised by the bank at the time of opening the RD account itself.  The repayment of maturity value of the deposit is however subject to payment of ALL the instalments on time.

Interest is compounded on a quarterly basis on this type of deposits and paid on maturity only. Additional preferential interest rates are offered by most banks to Senior citizens depositing money in RD accounts.

The formula used for calculating the interest is:

M = R [ (1+i)n – 1] ____________________
1- (1+i) -1/3

In this formula

M denotes= Maturity value

R = Monthly Instalment

r = Rate of Interest (i)/400

n = Number of Quarters

How Can you Fund your Recurring Deposit Account?

Most banks offer standing instruction facility whereby customers can instruct banks to automatically transfer specific amount on a specified date to an account held in the same/other banks. Hence while opening an RD account itself you can instruct the bank to transfer funds lying in your savings account into the RD account on a monthly basis. By issuing standing instruction not only will you be able to save time involved in visiting the bank personally to deposit the amount but will also be free of the hassle of remembering and ensuring deposit of instalment on the due date.

What are the Benefits of investing in Recurring Deposits?

Better returns. Interest rate on RD is normally the same as fixed deposits and thus greater than what you will earn from a savings account. To understand this better, here is an example.

Consider a scenario where a private bank is offering interest of 4% p.a. on a Savings Bank account and 8.75 % on a RD account

Rs 2000 deposited each month in a savings account and accumulated without being withdrawn or invested elsewhere over a period of period of 24 months will earn an interest of Rs 1859.31 at the end of two years.

On the other hand Rs 2000 invested in a recurring deposit for 24 months @ 8.75 (FD interest rate for a deposit of 2 years period) will earn interest of R 4594.44. This interest calculation is based on the assumption that the RD installments are all paid on time.

Discipline. When you commit to invest a specific sum of money each month in this type of account you develop a savings habit. Personally for me there have been numerous occasions when I have ended up spending money (shopping or purchasing things which I could have postponed to a later date) lying in my savings account which I had “planned to save”.

Simply put for most of us when we have funds easily available for withdrawal at our disposal it is not easy to control the urge to spend. On the other hand if we maintain an RD account the instalment amount would automatically get deducted from the savings account leaving little for us to indulge in!

Amount of deposit. Unlike fixed deposits where most banks and financial institutions require you to invest a lump sum amount to start the deposit, RD account can be opened  with monthly instalments as low as Rs 500 or Rs 1000. The minimum balance required to open an RD account can however vary from bank to bank.

Safety. Return on an RD account is guaranteed provided you do not default in payment of any of the instalments. Unlike stocks or mutual funds where in the short term it is not really possible to predict returns this is a very safe investment option.

Financial planning. Recurring deposits can be opened for a fixed duration of time. This allows investors to plan their savings and spending accordingly. Going with our initial example, my neighbour by investing Rs 2000 in an RD account for 2years will get to know the exact amount she will receive at the time of maturity of her deposit. She will thus be in a position to plan how to make up for the shortfall (if any) required for purchasing a two wheeler.

Basically this type of investment helps us to plan and figure out how to meet our short to medium term goals like- purchasing a vehicle, a washing machine, taking a vacation or renovating the house.

Ease of operation. Once you open an RD account and issue monthly standing instructions for payment of instalments there is no need for you to track the RD account. There are no operational requirements like maintaining minimum balance or payment of service charges etc. All that you need to do is to ensure that your savings account has enough funds to cover the payment of the monthly RD instalments on time.

Frequently Asked Questions

Is foreclosure of an RD account possible?

Foreclosure or premature withdrawal of funds held in an RD account is possible. In such a case the interest payable on foreclosure would be calculated for the period for which the funds had remained with the bank less a penalty (penal rate fixed in accordance with directives issued by the Reserve Bank of India from time to time).

Is it possible to borrow against RD?

Some banks in India do allow customers to borrow against RDs.

Is Interest on RD subject to tax?

Yes, RD interest is taxable. However unlike fixed deposits tax was not being deducted at source (TDS) by banks on the interest paid on recurring deposits. Banks used to repay the entire proceeds of the deposit along with interest to the depositor upon maturity. Thereafter the onus of paying tax on the interest income earned rests with the depositor.

Budget 2015 proposes to deduct tax at source for RDs as well.

What happens if the RD instalment is not deposited on time?

In case there is a delay in payment of an instalment during a particular month a penalty will be charged. The amount of penalty is calculated at the rate of interest applicable for the RD account plus an additional 2% . For example if the rate of interest for the RD account is 8.75% p.a penalty would be levied at 10.75% p.a.

This penalty is levied for the number of days of default (ie) if installment was due on the 10th of the month but was deposited only on 19th a penalty would be levied for 9 days @ 10.75%. The amount of penalty will be deducted by the bank from the total amount of interest paid at the time of maturity or foreclosure of the deposit.

What happens in case of frequent defaults in payment of instalment?

Most banks levy only a penalty in case of default of 1 or 2 instalments. However in case of frequent multiple default, banks have a right to close the RD account before maturity under advice to the customers.

Flexi RD Accounts

A number of banks nowadays offer RD account with an additional feature whereby the monthly instalment required to be deposited can vary within a pre-determined amount range. This unique feature offers flexibility to investors and at the same time protects them against penalty being levied for defaults made.

Conclusion

For people with limited funds at their disposal, looking to save fixed amount of money every month in a bank account, RD is a good investment option. The return on these deposits is guaranteed provided all the instalments are paid on time. RD accounts are fairly easy to open/operate/maintain. Most importantly it enables investors to accumulate sizeable reserves over a period of time by putting away a small portion of their savings every month.