The Government has put the axe on interest rates earned from small savings schemes, such as PPF, NSC and term deposits of post offices.
Here is a glimpse of the rate cut. The new rates of interest are applicable from 1st April 2016- 30th June 2016 (and will be revised for each quarter going forward) –
| Instrument | New Rate of Interest | Old Rate of Interest | Change | Tax benefit on deposit | Whether interest is taxable |
| PPF | 8.1% | 8.7% | -0.6% | 80C | Exempt |
| NSC (5 years) | 8.1% | 8.5% | -0.4% | 80C | Taxable |
| Sukanya Samridhi Account | 8.6% | 9.2% | -0.6% | 80C | Exempt |
| Kisan Vikas Patra | 7.8% | 8.7% | -0.9% | – | Taxable |
| Post office deposit 5 years | 7.9% | 8.5% | -0.6% | 80C | Taxable |
| Post office recurring deposit 5 years | 7.4% | 8.4% | -1% | – | Taxable |
| Post office deposit 3 years | 7.4% | 8.4% | -1% | – | Taxable |
| Post office deposit 2 years | 7.2% | 8.4% | -1.2% | – | Taxable |
| Post office deposit 1 years | 7.1% | 8.4% | -1.3% | – | Taxable |
This may come as a blow to many who used these schemes to park a bulk of their investments. In this article we will try to address 3 aspects of this rate cut –
- Why the rate cut happened?
- How bad this cut really is?
- What should one do to redeem this interest loss?
Why the rate cut happened?
Interest rates on small savings schemes were heavily regulated. Let’s not get into what the reasons were, but the income these instruments earned were not linked to market dynamics. Or government decided how much these schemes should earn rather than letting the market fix them.
As a result, a peculiar thing started to happen. Whenever RBI cut lending rates, so banks could lend at a low rates; the banks were not able to pass this benefit to borrowers. Borrowers are people like all of us who take loans from banks for buying a house or starting a business. If the bank lowered rate of interest on loans it meant their income would suffer, thereby putting a pressure on the deposit rate. Therefore, unless banks reduced the interest rates on fixed deposits, they found it hard to bear the interest loss on loan due to lower borrowing rates. Now the reason banks were not able to reduce interest rates on fixed deposits is, that these deposits would become highly unattractive to investors against other small savings schemes and the deposits with banks would fall.
The government wanted to move to a deregulated interest regime. Where markets define, how much an instrument should earn.
As banks showed their inability to pass on rate cuts to borrowers, government was force to take this move.
How bad this cut really is?
The moot question here is how much does this really pinch. Well, if you look at pure economics, these instruments never offered inflation friendly returns. Which means if the inflation rate was higher than the interest rate, you really didn’t make much money.
However, some of the schemes such as the PPF, senior citizens savings scheme and sukanya samridhi account, had a social goal and interest rates for these at least, should have been kept. PPF and senior citizen’s schemes provide for a secure retired life and in a country like India where there is no social net for the aged, this was important. Similar is the case with Sukanya Samridhi, which was only launched 2 years back and should have been kept as is.
A lot of tax savers, use these schemes to create a ladder effect – depositing some sum every month and gradually building a corpus over a 10-15 years’ time frame. With the reduced rates, what took 10 years to build will take 13-14 years. Those in their 50s and preparing for a retirement in the coming decade are sure to feel the pinch.
Not to forget that some of these schemes earlier enjoyed a bi-annual compounding which also recently changed to annual compounding, making their returns even smaller.
What should one do to redeem this interest loss?
Interest rate cuts certainly hurt in all the wrong places. But here are a couple of strategies you could use to counter the loss of interest income.
- PPF & Sukanya Samridhi still going strong – Remember that PPF and Sukanya Samridhi instruments continue to enjoy tax benefits under section 80C of the income tax act. Therefore, these are still in the favourable bucket. Your returns are tax free, so are the withdrawals and there’s tax deduction on investment; not too bad. Invest as much as you can in these – to build a secure, risk free corpus, sure to hold you in good stead. A maximum of Rs 1,50,000 can be claimed as a deduction under section 80C.
- Consider ELSS – If you want to build a wealth chest over time, ELSS is a decent bet. You can start a SIP for as low as Rs 2,000 every month. Be diligent with the SIP and keep going for a 5-7 years’ time. Pick a good fund with a commendable past performance. Investing in ELSS allows you to benefit from large gains from equity, without the time investment and follow up required in understanding stock markets. ELSS funds come with a lock of 3 years, but you can stay invested for a longer term. Returns from ELSS are fully tax free too, withdrawals are tax free; when you sell your ELSS mutual fund you pay no tax.
- There is a silver lining – If the market dynamics are to be believed this kind of interest regime will have a positive overall impact. Over the time, this could mean lower rates on home loans, lower rates on business loans, giving an overall positive thrust to the economy.
- Brace yourselves – How we wish we never had to say this! Though the government has said it would revisit the interest rates every quarter, these are bound to head south and well there is no other way but to prepare ourselves for what lies ahead.