Fixed Deposit provides you a method to lock you money for a specific period ensuring a fixed interest rate. The problem with FD is that your money is locked for the specific period and if you break it between tenure, banks impose a heavy penalty. Also a shorter term FD gets you lower interest than a higher tenure FD. I just took a look at the HDFC bank website for interest rates and realized that 1-2 years FD interest rate is very close to interest rates for 5 years or more FD, while significantly less interest rate for tenures less than a year.
This leads to a dilemma of choosing between liquidity and higher interest rates, when investing in Fixed Deposits.
FD laddering comes to rescue. The concept is very similar to rupee-cost averaging. The idea is to stagger the FD maturity over a period to get higher interest rates as well as access to partial amount of your investment at regular intervals.
Let me explain using a simple example. Consider an example that you plan to have around Rs 50,000 over 5 years of period say for your children’s education or down-payment of your house. But you may also fear that locking such amount for longer duration may not be prudent due to emergency needs. So instead of saving the money in 5 years fixed deposits, the strategy should be :
Invest 10,000 Rs in FD with tenure 1 Year
Invest 10,000 Rs in FD with tenure 2 Year
Invest 10,000 Rs in FD with tenure 3 Year
Invest 10,000 Rs in FD with tenure 4 Year
Invest 10,000 Rs in FD with tenure 5 Year
So essentially you staggered the investment across 5 years in different tenure. The advantage is that you get higher returns but also access to partial amount of your money at regular interval.
As the FD matures, you may decide to roll-over the FD into next 5 year FD.
In essence the advantages of laddering are
1) Lower holding period risk
2) Reduce interest rate fluctuations
3) Creates Liquidity
4) Provides regular income
5) Avoid pre-mature withdrawal penalty
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