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The Magic of Add-on Certificate of Deposits (Recurring Deposits)
Have you ever wanted to buy something like a new car, and you’ve been thinking about buying it for the last one year, but you still haven’t saved enough money to actually buy it without making yourself feel like you were emptying your entire wallet. Isn’t it frustrating that you want that cool extra feature added to your new car but it’s just too much for you to afford right now and you decide to have it done later.
I guess the same goes for all kinds of stuff like digital cameras, laptops, refrigerators and the latest television set. Why is it that we know we need to buy something but rarely end up being able to plan to actually make that purchase comfortable? Maybe it has to do with a lack of disciplined saving. Or maybe the circumstances this last year just weren’t right for you to save a lot of money. Either way it still doesn’t feel too good when you have to part with your money almost unplanned.
Well there are options to make sure every purchase you make is a planned and smooth one where you don’t have to worry that a sizable chunk of money is going to drain out of this month’s pay cheque. One of the options open to you is to invest your money over a planned period in a systematic investment plan that puts a small monthly investment by you into say a mutual fund.
Say for example you plan to buy a new Sony Blu-ray Home theatre system for about $400. You decided to save over a period of 10 months. So you would need to save about $40 a month for 10 months right? Wrong! With a mutual fund there is no guarantee about how much value appreciation or dividend you may receive over those ten months. If the value of the units of the mutual fund falls you stand to lose your money in the short term. Let’s not forget that in the long term mutual funds usually end up netting you a decent appreciation. In the short run though, there is no guarantee.
So that strikes investments in volatile high return markets out. Since the objective for your monthly savings is to spend the entire amount (principal + interest) at a pre determined date, it makes sense to put the money in a Certificate of Deposit, an Add-On CD (or a recurring deposit) to be exact. Add-on CDs allow you to deposit a fixed amount of money every month although some have certain restrictions over a regular CD. The beauty of the Add On CD is that you know exactly how much you need to deposit every month and exactly how much you will get and exactly when you will get it.
It’s true that the interest rate on CDs is usually at par or even lower than the inflation rate, but you’re not investing a huge sum in these CDs. You’re using the CD to ensure you can plan to have a certain amount of money by a certain time...guaranteed. What’s more a CD provides a higher rate of interest than a regular savings account so you’re not just letting your money rot.
The restriction mechanisms in CDs ensure you get penalized for early withdrawal and that in turn ensures forced discipline. In a normal savings account with no withdrawal restrictions you’re at the mercy of your will power.
The interesting thing about CDs is when you actually calculate the numbers. It can surprise you to know that there is a noticeable decrease in the amount you need to save if you choose to plan through CDs. Let’s take the example of a car you are planning to buy in India for Rupees 400,000. You’ve been planning to buy this car for the last 2 years. Now the recurring deposit rates in India hover around 7.5% per year (readers in the United States, don’t be alarmed at the high interest rate, our inflation rates are around 8.5% too ;-) typical of emerging economies.). Now if I was just randomly looking to save money without planning through a CD or recurring deposit a simple calculation would say that I need to save around Rs 16,666 (i.e. 400,000/24) every month for 24 months to make 400,000 rupees.
On the other hand, if I were to deposit the amounts in a recurring deposit or CD every month for 24 months, I would need to invest only Rs 15,400 to reach my goal of Rs 400,000 by the end of 2 years (interest compounded quarterly). That means I deposit Rs. 1,266 less every month and a full Rs.30, 384 lesser in total by the end of 24 months. Now that was Rs. 30, 384 rupees that I saved doing nothing but authorise a standing instruction to have my savings account debited by Rs.15, 400 every month. The reason for the large saving is primarily because of the power of compounding. Every quarter the interest on the deposits is added to my principal amount and the new interest amount is calculated after including the interest from the last quarter. In essence, I earn interest on my interest and this happens every quarter.
There is no doubt that a CD is not a great investment option. In fact in an economy where the inflation rates are higher than the CD rate of interest, a CD can’t even be termed as an investment because your money constantly loses value. But there really aren’t too many savings options out there that help you plan your near term expenditure this well.
If this article has gotten you interested in CDs, and you're looking to learn more about other popular fixed income securities, The Handbook of Fixed Income Securities might do for some interesting readiing.