Should you opt for auto renewal of deposits?

Bank deposits form an integral part of an individual’s goal-based investments. An important decision you may have to take relating to bank deposits is whether to opt for auto renewal on maturity. In this article, we show why auto renewal may not be an optimal choice.

Maturity-matching deposits

Bank deposits offer certainty in cash flows. Ignoring the small credit risk associated with such investments, you know the maturity value you will receive when you invest in a cumulative deposit. Similarly, you know the maturity value when you start a recurring deposit.

Of course, most of us cannot achieve our life goals investing in just bank deposits, given its low returns. So, it is important that we also invest in equity. But the higher expected return on equity also means higher risk. You do not know the value your equity investments will fetch till you sell them. Bank deposits offer stability to your investment portfolio whereas equity provides upside potential.

It is in this context that maturity-matching your deposits become important. For your goal-based investments where certainty in cash flow is important, you should invest in bank deposits with maturity that matches with the time horizon for your life goal. So, if you are pursuing an eight-year objective, your deposit should be for eight years. But what if your time horizon is 15 years? Banks may not offer deposits for such a long term. That is when renewal of deposits comes into play. Should you consider auto renewal of your deposits on maturity?

Reinvestment risk

Auto renewal is a convenience. Your deposit is typically renewed for the same period at the prevailing rate at the time of the renewal. For instance, if your initial deposit was for one year at 5.25% per annum, your deposit will be typically auto-renewed for one year at, say, 4.50% if that is the current one-year deposit rate. You are exposed to reinvestment risk when you auto-renew your deposit. This is the risk that you may have to reinvest the maturity proceeds from your original deposit at a lower rate at the time of renewal.

So, auto renewal is to ensure that you reinvest your proceeds immediately on maturity of the deposit, not to lock-in to the same rate of interest as the original deposit. Auto renewal arises in two situations — when you must reinvest the proceeds for the remaining time horizon to achieve a life goal and when you want to reinvest surplus cash. In both cases, you may want to explore other investment avenues before choosing to renew your deposit. In any case, if you forget to renew your deposit, you will receive an interest rate that is either the savings account rate or current interest rate pertaining to the original term of the deposit, whichever is lower. So, why set up auto renewal?

Conclusion

You may want to auto renew your deposit because you fear you will consume the maturity proceeds for purposes other than what it was intended for. One way to reduce this risk is to have a master savings account — a bank account earmarked for your investments. You should set up your recurring deposit, systematic investment plans (SIPs) and other investment from this account. That way, all interest income, and dividends and sale proceeds will be credited into this account. Importantly, this account is never used for paying utility bills and other household expenses.

You must maintain your master savings account in a bank where you do not maintain your general savings account. With limited requirement to access this account, you can reduce the temptation to spend the sale proceeds or income returns. Also, if you do not find better avenues to invest the maturity proceeds, you can always open a new deposit. Therefore, request your bank to credit the maturity proceeds into your savings account.

(The writer offers training programmes for individuals to manage their personal investments)