Interest rates fluctuate. And while rising rates are troublesome for borrowers, savers welcome them.

Like regulators in several countries, the Reserve Bank of India is on a rate hike spree. This cycle is not over and is expected to continue. It will have a definite impact on loans as well as deposits (read more here). While rate increases are passed on faster for loans, bank deposits lag on this front.

With four consecutive rate hikes in less than six months, there is now a definite upward push on fixed deposit interest rates as well.

While you may be tempted to book your FDs immediately upon hearing this, there is something else to keep in mind. There are high chances that the RBI will continue to increase policy rates further.

So, the FD rates offered by banks are also expected to increase in the future. This means that if you book your FDs now itself, you may miss out on a better rate in the future.

To better optimise returns from your bank FDs, you need to consider the strategy of “laddering” FDs.
 

STEP BY STEP

While rising interest rates are a big relief for savers, especially senior citizens who depend a lot more on interest income, the FD laddering technique can be used to further take advantage of rising interest rates.

FD laddering is about dividing your investment in FDs and spreading them over multiple smaller FDs with different maturity periods. This gives you a chance to earn better returns in a rising rate environment and also helps better manage your liquidity requirements.

Let’s take a simple example to better understand this.

Suppose you have Rs 20 lakh that you want to invest in an FD. Until recently, you may have been getting FD interest of 5 percent. But now, banks offer 6.25 percent.

It is tempting to book an FD and lock in this higher rate for several years. While the idea is correct, we also need to remember that FD rates are expected to increase further.

How much?

No one can predict that, but 7 percent is an easy possibility in the short term and 8 percent in the medium term if the economic environment demands rate hikes.

So, if there is a possibility of getting 7-8 percent in a year, why would you lock in an FD at 6.25 percent for several years? Here is where you can ladder your FDs. One way to do this is given below:

Instead of making one FD of Rs 20 lakh, divide the money into four parts of Rs 5 lakh each.

Now create FDs for each part (Rs 4 lakh) with different tenures – say, 12 months, 15 months, 18 months, and 21 months.

Let’s say your bank offers FD rates of 6 percent (12-15 months) and 6.25 percent (for 15-24 months). Your FDs will earn as follows –

1st FD (12 months) – 6%
2nd FD (15 months) – 6%
3rd FD (18 months) – 6.25%
4th FD (21 months) – 6.25%

The bank also offers 6.35 percent for a five-year FD, which you might be interested in for a long tenure FD. But interest rates are expected to rise for the next one year or so, we choose FD laddering as explained above.

Now let’s see what happens when the FDs start maturing. If our assumption that FD rates would rise was correct and banks then start offering 7.5-8 percent rates on FDs, here is what you can do:

- When the first FD (6 percent) matures after 12 months, you can book a new FD at 7.5 percent for 2 years
- When the second FD (6 percent) matures after 15 months, you can book a new FD at 7.5 percent for 3 years
- When the third FD (6.25 percent) matures after 18 months, you can book a new FD at 8 percent for 3-4 years
- When the fourth FD (6.25 percent) matures after 21 months, you can then book a new FD of 8 percent for 4-5 years

This results in a ladder of FDs, with each maturing and getting booked at higher rates for several years. This is what FD laddering does – climb the interest rate ladder, one FD at a time.
 

OTHER BENEFITS

- When you ladder your FDs, you get periodic liquidity as well as and when an FD matures. If you have five FDs of Rs 4 lakh each maturing after the other, that is better for liquidity management than holding a single FD of Rs 20 lakh.

When you need a small amount of money, you won’t have to make a premature withdrawal from one large FD. Instead, one small FD can be used and the other unused ones remain as they are.

- Nobody can predict the rate cycles perfectly. So once your initial FD ladder is set up, you don’t have to guess when rates will increase or decrease. You average out your interest rate as you have different FDs with different rates maturing at different times.

You may not be able to book all FDs at the highest rate, but you also don’t book them all at the lowest rates. So, you get the best of both worlds of different interest rates with periodic liquidity windows when you set up an FD ladder.