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You have heard of fixed deposits irrespective of who you are - a boomer (born before 1964) or a Gen Z (born after 1997). You have most likely invested in one as well.
But somehow you were never able to figure out how fixed deposits exactly work.
Why are banks paying you interest for simply depositing money with them?
What are they doing with the money exactly?
These are fair questions to ask. After all, you are trusting the banks here to keep your money safe, pay interest on it and return it as and when you need it.
So, let’s understand how fixed deposits work from your perspective as well as the bank’s.
How Do Banks Make Money?
We first need to understand how banks make money.
Once this becomes clear, most of your questions around the functioning of fixed deposits will be answered.
3 steps in which banks make money:
- Accept money from savers/depositors and pay them X% interest rate
- Lend money to borrowers and collect Y% interest rate
- Ensure that Y is always greater than X
As simple as that.
If you think about it, the bank’s business starts with borrowing money from savers/depositors like us.
If there are no depositors, banks would not be able to function anymore because they won’t be able to lend and collect interest from their borrowers.
Note: We have simplified the bank’s business model to a great extent without compromising on the essence.
How Do Fixed Deposits Work?
There are two stakeholders here - you and the bank!
Your Side of the FD Story
For you, investing in a fixed deposit is like planting a seed to watch it become a shrub.
You deposit an amount with the bank for a fixed period. During the FD tenure, your money earns interest.
The rate offered on bank deposits is typically higher than that on your regular savings account - this is often your trigger to keep your money in FDs.
Once you have put your money in an FD, you wait for the FD to mature. Once it does, you get your initially invested money back along with all the interest it has earned (cumulative FD).
Note: In a non-cumulative FD, the interest your money earns is credited to your bank account regularly and when the FD matures you only get your initially invested amount back.
You probably know the story until here. But what exactly happens with your money when it is growing in a fixed deposit.
This is where we need to understand the bank’s side of the FD story.
The Bank's Side of the FD Story
The bank has accepted your money and has to pay interest on it as promised until the FD matures.
So what does the bank do with your FD that helps it pay interest to you?
It loans out that money to home loan, car loan, personal loan etc. borrowers!
The banks charge an interest on these loans.
To make this a viable business model, the interest rate the banks charge on loans has to be higher than the interest rate they pay you on your deposits.
No wonder FD rates are in the 7-8% range while loan rates are in the 10-15% range.
In banking terms, this difference in interest rate is called net interest margin or NIM. Higher the NIM, the more profitable a bank is.
Banks are Struggling to Get Fixed Deposits in 2024
As we saw, collecting deposits is the first step for banks to conduct their business.
It becomes a big problem for banks if they are not able to attract depositors to deposit money with them. The problem becomes worse when the demand for loans is high.
Think about a chocolate company that is facing heavy demand for its chocolates but isn’t able to produce them because they don’t have enough cocoa.
This is exactly what the banks are experiencing in 2024 (since 2023 actually!).
And they have implemented a solution to solve this problem.
It’s 2024 and FD rates are high again
Banks have raised their FD rates to attract deposits. In fact they are still raising it.
Only last week, SBI raised its FD rates by up to 0.75% across tenures.
This has created a very favourable situation for you. It has given you the chance to lock-in high FD rates that were not available for many years.
Happy Investing!
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