What Is a Fixed Deposit and How Does It Work?

A fixed deposit (FD) is a savings instrument offered by banks and other financial institutions, allowing individuals to deposit a lump sum of money for a predetermined period at a fixed interest rate. This type of account provides predictable returns. Unlike a standard savings account, funds are held for a specific duration, making it suitable for those who do not require immediate access to their capital. Fixed deposits are often referred to as certificates of deposit (CDs) in the United States.

Core Characteristics of Fixed Deposits

Fixed deposits are defined by several key attributes that differentiate them from other savings vehicles. A primary characteristic is the “fixed tenure,” meaning the money is locked in for a specific duration, which can range from as short as seven days to as long as ten years. Another defining feature is the “fixed interest rate,” which is determined at the time of investment and remains constant throughout the chosen tenure, providing predictable earnings regardless of market fluctuations.

Interest on fixed deposits can be calculated in two main ways: simple or compound interest. Simple interest is calculated only on the initial principal amount, while compound interest is calculated on both the principal and any accumulated interest from previous periods. Most fixed deposits utilize compounding, where interest earned is added back to the principal, allowing the investment to grow more significantly over time. More frequent compounding, such as monthly or quarterly, typically yields higher returns.

Depositors also have options for how interest is paid out. With a “cumulative” fixed deposit, the interest is compounded and reinvested with the principal, with the total amount paid out as a lump sum at maturity. Conversely, a “non-cumulative” fixed deposit pays out interest periodically, such as monthly, quarterly, or annually, providing a regular income stream to the depositor. While these periodic payouts offer liquidity, they typically result in lower overall returns compared to cumulative FDs due to the lack of compounding on the disbursed interest.

Some fixed deposits are specifically designed to offer tax benefits. Certain tax-saving fixed deposits in some jurisdictions come with a mandatory lock-in period, often five years, and may allow for tax deductions on the invested amount up to a certain limit. While the principal investment may offer tax benefits, the interest earned is generally taxable income.

Required Information for Account Opening

Opening a fixed deposit account requires individuals to provide specific information and documentation to comply with regulatory requirements, primarily “Know Your Customer” (KYC) guidelines. KYC procedures are mandated by laws such as the Bank Secrecy Act and the USA PATRIOT Act to verify customer identity and prevent illicit activities.

Applicants typically need to provide proof of identity, such as a valid government-issued photo identification. Common forms include a driver’s license, state ID, or passport. In addition to identity, proof of address is necessary, which can be demonstrated with documents like a recent utility bill, a bank statement, or a current lease agreement.

A crucial piece of information required for U.S. citizens and residents is a Social Security Number (SSN) or an Individual Taxpayer Identification Number (ITIN). Financial institutions use this number for tax identification and reporting interest income to the Internal Revenue Service. Some institutions may also request nominee or beneficiary details. Naming a nominee ensures funds are transferred to a designated individual upon the depositor’s death, simplifying the process for beneficiaries.

The Fixed Deposit Process

Once all necessary information and documents are gathered, the process of opening a fixed deposit can begin. Applications can be submitted online via websites or mobile apps, or in person at a bank branch.

Upon reaching its maturity date, a fixed deposit offers the depositor several options for managing their funds. The most common choices are renewal or withdrawal. Depositors can opt to renew the fixed deposit, which means reinvesting the principal and any accrued interest for a new term, often at the prevailing interest rates. Many banks offer automatic renewal services.

Conversely, depositors can choose to withdraw the principal and all earned interest at maturity. This concludes the fixed deposit term, and funds are typically transferred to a linked savings or checking account. Financial institutions usually send a maturity notice prior to the maturity date, outlining options and providing a grace period.

While fixed deposits are designed for funds to remain untouched until maturity, early withdrawals are sometimes permitted. If a depositor needs to access their funds before the fixed tenure ends, financial institutions typically impose penalties. These penalties usually involve forfeiture of a portion of the interest earned or a reduction in the interest rate. The penalty amount varies by institution and terms, often calculated as a certain number of months’ worth of interest. In situations where the earned interest is less than the penalty, a portion of the principal may be affected.