Is it a good time to invest in an FD since interest rates are rising?

Interest rates have been steadily climbing in recent months. If you plan to invest in a fixed deposit (FD), it should be music to your ears.

That's because, theoretically speaking, growing interest rates increases FD returns.

But is it as straightforward as that?

Let's explore this so you can make a better investment decision.

Mind the gap
When COVID pandemic struck us in 2020, the Reserve Bank of India (RBI) was compelled to pump in more money in the banking system. They did this to ensure banks had sufficient money to lend.

Fast-forward to now, banks still have surplus money in their system, which is why they are in no hurry to raise their FD rates even as the RBI is revising the interest rates.

Please remember that when the RBI raises policy rates, banks' loan rates are hiked with immediate effect. But that's not the case with FD rates. In fact, it is up to the banks to decide how much money they need and whether it is necessary to raise interest rates on FDs.

That said, banks' excess funds may not last long.

Since they are giving away loans at nearly twice the pace of deposits, their cash reserves are running thin. As a result, they will have to turn to us for more money in the next six months or so.

This is when they'll have to increase their interest rates on fixed deposits (FDs) to encourage us to park our money with them.

As we speak, there are indicators of that happening, with banks exploring alternatives to raise interest rates, such as short-term borrowings like commercial papers.

What you should do
Hence, it's ideal to avoid going for any long-term fixed deposits. While the bigger banks are currently offering modest FD rates (1 to 2-year range) of 6-7 per cent, the imminent liquidity squeeze will prompt them to push the rates in the following months.

So, if you don't lock yourself in a longer-duration FD, you will have the flexibility to invest at a later time when the interest rates are on the higher side.

In the meantime, if you must invest in a fixed deposit, go for a shorter-duration one, preferably for less than a year.

However, we would suggest you look at liquid funds for such a short duration. Even though their returns are fairly similar to that of FDs, they give you the flexibility to withdraw your investment at any given time. This facility is not available with FDs as you would be handed a 0.5-1 per cent penalty if you exit prematurely.

You can click here to know more about liquid funds, or here to get the list of best liquid funds recommended by our analysts.

So, if you invest in a liquid fund, you have the option to easily shift your money to a longer-duration FD as and when banks increase their interest rates.