Looking for a short term loan to fund an emergency in the family? Among various ways to raise short term debt, a loan against your existing fixed deposit might just be one of the quickest. In this post, I will discuss loan eligibility, interest rate and pros and cons of such loans. We will also see if it makes sense to go for such loan.
How Much Loan Can I Get?
The banks typically offer loan/overdraft facility up to 90% of the value of fixed deposit. The exact percentage may vary across banks. For instance, Axis Bank offers overdraft facility up to 85% of value of your fixed deposit. State Bank of India offers both demand loan and overdraft facility up to 90% of the value of FD.
What Is the Rate of Interest?
The rate of interest is 1-2% above the rate of fixed deposit. Axis Bank charges 2% above the deposit rate. SBI charges 1% over the deposit rate.
What Is the Loan Tenor? How Is the Loan Repaid?
The loan tenor can’t exceed tenor of the deposit. The bank may have additional internal restrictions on loan tenor. For instance, at SBI, the tenor cannot exceed 5 years.
Repayment schedule (or method) can vary across banks. You must verify the repayment method before taking the loan. It depends on the type of credit facility too. If it is taken as a demand loan, then you may have an EMI like repayment schedule. With overdraft facility, you may get credit line on renewable basis. i.e., your borrowing limit gets reinstated once you repay. You merely need to keep paying interest. If you do not repay within specified period or before FD maturity, your FD maturity amount will be used to square off the loan.
You can close the loan whenever you wish.
What Are the Benefits?
- A loan against a fixed deposit will be much cheaper than a personal loan.
- You can expect process to be quick. Since the bank owns the deposit, it merely needs to mark a lien on the fixed deposit to create security.
- Such loans against fixed deposits may not have any pre-closure charges.
- There may not be any other charges apart from interest rate. So, you won’t have to incur any processing fees etc. However, you are advised to verify this information with your bank.
- Depending upon terms of the credit facility, you may be required to pay only the interest amount (and not principal like in EMI based repayment schedule). You may get the liberty to make principal repayment as and when your cash flows permit.
Points to Note
- You CANNOT avail loan/overdraft facility against tax-saving fixed deposit (with a lock-in of 5 years).
- Banks provide loans only against their fixed deposits.
- There can a minimum loan amount. With Axis Bank and State Bank of India, the minimum loan amount is Rs 25,000. SBI also has an upper cap at Rs 5 crore.
Does Loan Against Fixed Deposit Make Sense?
You have at least two options.
- Either you can take a loan against your bank fixed deposit OR
- You can break the FD prematurely and use the funds to meet your requirement.
In my opinion, it is not prudent to earn 8% on the FD and pay 10% on the loan against fixed deposit. And the difference is not just 2%. You need to take into account post tax FD interest. For someone in 30% tax bracket, the effective post-tax return on FD is only 5.6% p.a. There is no tax benefit for repayment of loan against fixed deposit. So, the true comparison is 5.6% p.a. vs. 10% p.a. This is for a person in 30% tax bracket.
Another point to consider is the applicable penalty for premature exit from fixed deposit. If you close your FD prematurely, you may be offered interest rate for the term you remained in the deposit (and not the original contracted rate). There may be additional penalty as mentioned in terms and conditions of your fixed deposit receipt. However, the penalty is only limited to interest (and not the principal). Many times, I get the argument along this line. “I opened FD at a very high rate. These days, rates are not as high.”
In general, do not opt for loan against your bank fixed deposit. Rather, break your fixed deposit and use the funds to meet your requirement.
When Can Loan Against FD Make Sense?
I can foresee utility of loan against FD if the loan amount is much lesser than the FD amount and the interest rates have gone down significantly after you opened the fixed deposit. Penalty for breaking FD is also important variable.
Even though I have argued above that you must not opt for loan against fixed deposit because you pay more than you earn, taking a loan might be a better idea in specific scenarios.
Suppose you opened a fixed deposit of Rs 10 lacs for 5 years at 9% p.a. The fixed deposit is with annual payout (and not cumulative). After 2 years, you need a loan of only Rs 2 lacs. The prevailing FD rate for 3 years is only 7% p.a.
- If you do not break the fixed deposit, you will earn an interest income of Rs 4.5 lacs in 5 years. Considering income tax rate of 30.9%, your net income will be Rs 3.11 lacs. In this case, you will have to take loan (say, overdraft facility) of Rs 2 lacs. For a loan of Rs 2 lacs at 11% p.a. (9% + 2%), the interest for three years will be Rs 66,000. Hence, your net income is Rs 2.45 lacs (Rs 3.11 lacs – Rs 66,000).
- If you break this FD after 2 years, you will earn interest for 2 year FD (i.e. 7.5% and not 9%). Secondly, consider penalty of premature withdrawal at 1%. Hence, the rate becomes 6.5% p.a. You will earn interest of Rs 1.3 lacs (Rs 10 lacs * 6.5% * 2). Post-tax, this income becomes Rs 89,830. After breaking FD, you re-open another FD of Rs 8 lacs at 7% for 3 years. You will earn interest income of Rs 1.16 lacs post-tax (Rs 1.68 lacs pre-tax). Total post-tax interest income of Rs 2.05 lacs (Rs 89,830 + Rs 1.16 lacs).
You can see you are better off continuing with this fixed deposit and taking a loan to bridge the short fall. You save ~ Rs 40,000 by continuing with the FD and not taking the loan. Do note I have chosen this case to highlight this scenario. For instance, if the loan amount was Rs 5 lacs, you would have been better off breaking the FD rather than taking the loan.
Loan against a bank fixed deposit may not be as useful. In most cases, you may be better off breaking the fixed deposit rather than taking a loan against it. However, there might be specific scenarios where taking a loan might be a better idea. A simple spreadsheet analysis will tell you what to do.