What’s the best way to handle an emergency when you have a fixed deposit (FD)? Is it smarter to take a loan against the FD or repay the loan using the FD money itself?
—Name withheld on request
When liquidating an FD for an emergency, there are a few financially prudent options that one could consider. These options aim to minimize the cost of borrowing and optimize the use of the FD.
Cheapest loan option for short-term needs: If the emergency requires a short-term financial outlay, utilizing the loan against the FD might indeed be the most cost-effective option. This is because loans against FDs typically come with lower interest rates compared to unsecured loans like personal loans or credit card advances, as they are secured against the FD. The rationale for this approach lies in the cost of capital. When the cost of breaking the FD (considering the loss of interest and potential penalties for premature withdrawal) is higher than the interest you would pay on the loan against the FD for a short duration, it makes financial sense to opt for the loan. This is particularly true if you anticipate being able to repay the loan in the near term. By doing so, you maintain the integrity of the FD, allow it to continue accruing interest, and avoid the costs associated with early withdrawal.
Repayment of the loan from principal and utilization of FD balance: Another approach, if faced with an emergency, is to repay the outstanding loan against the FD from the principal amount of the FD itself. By doing this, you would effectively be reducing your FD investment, but you would also be eliminating the loan and any interest accruing on it. If, after repaying the loan, there remains a balance in the FD, you can use that balance for the emergency at hand.
This approach may be advantageous if the remaining term on the FD is long and the interest you would have earned on the principal repaid is less than the interest you would owe on the loan. Moreover, this option could be preferable if the penalties for partial withdrawal from the FD are less severe than those for full premature withdrawal. It would be a strategic move to carefully calculate the difference between the cost of continuing the loan (including interest payments) versus the loss of interest and penalties from breaking the FD.
In both scenarios, the decision should be based on a thorough analysis of the costs involved in breaking the FD versus the costs of borrowing, as well as an understanding of your cash flow situation. If repayment of the loan can be managed quickly, the cost savings from lower interest rates on loans against FDs can be significant.
Raj Khosla is founder and MD, MyMoneyMantra.com
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Published: 19 Dec 2023, 06:50 PM IST