Banks give additional interest on deposits for a specific period

[mommykoko]

Any specific financial reason behind banks giving an additional percentage of interest for deposits made for a specific period.
for e. g., hdfc bank gives

7.1 % for upto 18 months,

7.25% for 18 21 months, and

7.0% for 21 months +

is there any financial significance to this period, which seems to vary from bank to bank?

just a curiosity question looking for insights

 

[godisiam]

@mommykoko By keeping the interest rates high only for certain very specific time periods and lower for all the remaining terms, banks are able to ensure that they pay low interest to those who are making unforeseen (premature) withdrawals. Those specific terms with higher rates are to attract new FD customers. On the rare occasion that an unforeseen (premature) withdrawal coincides with the special period, this plan fails.

As far as inconsistency in the relationship between rates and terms (time period), it is due to expectations about future interest rates. Interest rates may be expected to be high in some time periods in the future and low in others.

If anything in my answer isn't clear, feel free to ask a follow-up question and I will try to clarify.

 

[iancase]

@godisiam Today I learned something new.

 

[mommykoko]

@godisiam investors will compare and choose the bank where the rates are higher for the same period, so most banks tend to keep them more or less same or close.
the examples that i am referring to are the ones that have a higher rate for a small incremental period within the range. sure it is an attraction, but i am not convinced about the premature withdrawal logic given. .
any withdrawal finally gets interest as per the banks chart or table minus the penalty (usually 1 % ) for the period the deposit was held, so higher rate implies higher penalty is simply notional.
the case for example if the depositor's ideal period is 1 year, but opts for 17 months and breaks it in 13 months, he would get less than what he would get for a 1 year deposit had he committed to it before, but isn't that always the case with all premature withdrawals?

finally, aren't rates fixed with the hope and assumption that most depositors would stay and penalties decided based on the case of otherwise?

 

[godisiam]

@mommykoko Banks neither hope nor assume that most depositors would stay for the full term, especially in the case of long-term deposits. For example, HDFC Bank is currently offering an interest rate of 7.15% on deposits of exactly 35 months. If you make a deposit of even one day more or less than 35 months, you get a lower rate of 7%. Do you think the bank would hope that you don't withdraw early? If you withdraw in 34 months, the bank will not only gain the penalty (reduction in interest rate for premature closure) but also save an extra 0.15% per annum by putting you in a lower interest bracket!

If the banks decide to offer 7.15% even for 33 months and 34 months thinking that there's nothing special about 35, they will lose out when people prematurely withdraw. Even if offer 7.00% for 35 months also, they may lose out on deposits because some customers may go to other banks offering higher rates. Note that customers have the choice of going to competing banks at the time of making the original deposit. And they can be flexible with the term at that time. At the time of unforeseen (premature) withdrawal, they don't have any such choices. They'll have to accept the interest rate applicable based on their time of need.

 

[mommykoko]

@godisiam you are making an assumption that only depositors with 35 months are prone to withdraw. i have observed these periods vary between banks. some have a higher payout for 1 yr 25 days (390 days). does this bank assume that this is a vulnerable period for their depositors? in summary, you are explaining the benefits of premature withdrawal for banks and saying these interest rate charts are an exercise of depositors psyche.

 

[godisiam]

@mommykoko I said “for example” and cited one example. I never assumed that only depositors who invest for 35 months are prone to withdraw early! The same logic applies for 390 days also. Banks don’t need to assume that it is a vulnerable period. There’s no magic number. If they make the special term for 380 days instead of 390 days, the strategy will still work just as well for banks. People will still occasionally withdraw early due to unforeseen reasons and miss out on the special rate. The key (for the banks) is to ensure that the special rate is only for a very precise term and not for even one day more or less than that.

 

[godisiam]

@dancer12 This doesn’t make sense. Bank liabilities (mainly deposits) are short term and assets (loans given out by them) are long term. This practice is called maturity transformation.

I think your point about getting to balance the cash flows isn’t correct.

FD interest rates are based on expectations about future interest rates. For example, if a bank expects interest rates to be high in 2025 but low in 2026, they’ll offer high rates on 22 month FDs (maturing at the end of 2025) but lower rates on 34 month FDs (maturing at the end of 2026).

 

[dancer12]

@godisiam What I wrote has been confirmed with some one who works in treasury of a Bank. May be it's not the only factor they consider but it definitely is one of them.

 

[mommykoko]

@dancer12 nice perspective. thanks for sharing

 

[summertt5]

@mommykoko On a very simple level, this is how banking works. Banks take your deposited money and invest it in other places like loans and bonds.

If you put a 6 month FD, your money will only be with them for 6 months after which it'll be gone from their system. So their options to play around with that money is less.

If you put a 5 year FD, bank has a guarantee that your money will be with them for entire 5 years and they can confidently plan to invest it over the next 5 years.

The guarantee that they can hold your money longer gives them more assurance to plan their investment, and reduces their risk, which makes them more money.