Recurring Deposit Rates
A particularly vexing topic for all new investors is why the rate of interest for a Recurring Deposit (RD) varies from bank to bank. It is a very common question and it deserves an answer that does not involve complicated mathematical formulae. The RD is, strictly speaking, an annuity investment. This means that the bank’s customer deposits a fixed sum of money per year in an RD scheme. So the amount of interest generated by the account depends on the bank’s internal policy. The returns from the RD can be calculated using RD calculator. This policy is updated as per current market rates and so on.
Behind The Scenes Operations
Every bank borrows its money from the Reserve Bank of India (RBI) to lend money to its own clientele. This money is of course, not lent by the RBI free of interest and is lent in lieu of accepted Government securities. The rate at which it lent is known as the repo rate. Now, after the money lent to the bank, the bank, in turn, evaluates its financial assets and all its liabilities. That is, the total amount of money owed to it and the total amount of money that it owes to other entities.
Once this assessment is done, the bank a benchmark on its interest rates. This benchmark is the Benchmark Prime Lending Rate (BPLR). The bank cannot lend money at a rate below the BPLR. Depending on the current repo rate of the RBI, the bank evaluates how much above the BPLR it can afford to pay as interest to its customers. Now, seeing as the bank decides its BPLR depending on its assets to liability ratio, the overall interest of the RD varies from bank to bank.
The RBI does not fix the interest rate for the RD. It only fixes how much interest it charges the bank when it is lending money to the bank. As a result, there is no fixed rate of interest for RDs pan India. The actual rate depends entirely on the bank itself and on what its individual assets and liabilities are at the time. Now, the BPLR can change for a bank based on the market, but the rate of interest will not change for an ongoing scheme. This means that new customers will get the new rate of interest. The existing customers will not.
What All This Means In Simple Terms
Let us take an example to understand things more clearly. Say an institution lends an individual a sum of one hundred rupees. In exchange, the institution deducts four rupees in cash and an additional twenty-one rupees in bonds as security. So, effectively, the individual can lend out seventy-five rupees himself and the twenty-five rupees deducted is the repo rate.
Now, suppose the individual has a cow that gives milk worth twenty rupees every day. That is the person’s asset. But then the person borrows grass worth eight rupees every day to feed the cow. So in addition to the hundred that is owed the institution, the individual also owes eight rupees worth of grass every day. These are liabilities and must eventually be paid off.
So, in order to maintain a profit, the borrower decides that one needs to get a return of at least one hundred rupees from the money that is collected from independent investors and personal investments. This rate of return is decided exclusively by this individual depending on particular assets and liabilities. It has nothing to do with the lending institution. In this scenario, the institution is the RBI, the individual is the bank, and the independent investors are the bank’s RD customers.