Loan against FD - worth it?

Bank FD rates have gone up as of this writing. It is possible that some of us have FDs created 1 or 2 years ago, which offer much less interest rate than that being offered today. Sometimes, the difference could be 2% or more. In this case, a natural question that could arise is whether one should take loan against the existing low-rate FDs by paying 1% additional interest and create new FDs from the loan disbursed?

For example, I had an FD that gave 6.25% interest. Currently, there are FD options that offer rates as high as 8.25% (for senior citizens). Loan could be availed on the existing FD at 7.25%. So, one can be tempted to take a loan at 7.25% and create an FD out of it that offers 8.25%. You get 1% more even after paying the loan interest. Is there any catch? 

Yes - there is. You must factor in the tax that ought to be paid on the new FD. The interest that you pay on a loan taken against FD doesn't get any tax benefits, but the interest that you get on a new FD is taxable as per your income tax bracket.

Say the FD interest rate is R%. 

• If you are in a 30% tax bracket, then the post tax interest rate is : 'R%* (70% -  (30%*4%))' (4% is CESS that you pay on the tax). 

• If in the 20% tax bracket, the post tax interest rate is ' R%* (80% -  (20%*4%))  ' .

• And so on.

In the example above where return is 8.25%, the effective returns for different tax brackets are as follows:

Pre-tax Return on FD	8.25%
Tax Bracket	Post Tax Return
30%	5.68%
20%	6.53%
10%	7.39%
0%	8.25%

As is obvious from the table above, in our example, it makes sense to take a loan only when you are in the 10% tax bracket or lower.

Apart from that, in certain cases, interest on loan could be compounded monthly, so the effective interest rate that you pay on loan will turn out to be higher than simply (1% + FD interest rate offered on quarterly payout). You can calculate the effective interest rate on loan for quarterly loan payments using the method shown in this blog: https://investing-kds.blogspot.com/2023/04/comparing-fixed-income-instruments.html 

Conclusion: Before taking a loan against an existing FD, calculate the post-tax interest rate that you would get on the new FD. Only if the post-tax return is higher than the interest rate on the loan should you consider taking a loan.