Breaking an FD early: what the penalty really costs

A penalty that sounds small

When you close a fixed deposit before maturity, banks usually cut the interest rate. The penalty is stated as a percentage point, commonly 0.5% or 1%, and it sounds trivial next to a ₹5,00,000 deposit. It is not, because it is taken off the rate and applies to the whole balance for the whole time it ran.

The sums below use annual compounding to keep the arithmetic easy to follow. Banks usually compound quarterly, which changes the figures a little but not the shape of the result.

The example

You booked ₹5,00,000 for five years at 7%. After three years you need the money. Compare what you would have after three years at the contracted rate with what you get after a penalty.

A 1% penalty is not "1% of ₹5 lakh", which would be ₹5,000. It is about ₹17,000, because the lower rate was applied to a balance that had been growing for three years. The cost rises with both the size of the deposit and the time it has run.

What you give up beyond the penalty

Leaving early also forfeits the remaining two years at the contracted rate. If you had held to maturity, the ₹5,00,000 at 7% would have become 5,00,000 × 1.07⁵ = 5,00,000 × 1.402552 ≈ ₹7,01,276, an interest of about ₹2,01,276. Breaking at three years with a 1% penalty ends the deposit with ₹95,508 of interest. The fall is not only the penalty; it is also the loss of an asset that was still paying a rate you may not be able to match today. That second part is a matter of whatever rates have done since you booked it.

The cheaper way out for a short need

If you need cash for a few weeks or months, borrowing against the FD can be cheaper than closing it. Banks commonly lend against a deposit at a rate a point or two above the FD's own rate, and the deposit stays in place earning its interest. Your real cost is the spread, not the whole rate.

For example, a loan of ₹1,00,000 for six months at a rate 1 percentage point above the FD rate costs a net 1% × ₹1,00,000 × 0.5 = ₹500 after counting the deposit's own interest. Breaking an FD of the same size to raise that cash would have meant the penalty on the full amount, for the part of the deposit's life that had already run. The loan's margin and any processing fee vary by bank, so ask for both before comparing. For longer needs the comparison shifts, and if the need is permanent, the loan's cost keeps running while the break is a one-time hit.

A short checklist before you break one

1. Read the receipt. Penalty size, the minimum period before any interest is paid, and whether partial withdrawal is allowed are all set per bank and sometimes per product.
2. Check whether a partial break works. Some banks allow part of the amount to be withdrawn and leave the rest running at the original rate. Others close the whole deposit.
3. Price the loan against the FD. If the need is under a year, this is often the lower-cost route.
4. Note the tax. Interest on an FD is taxable each year at your slab rate even when it is not paid out until maturity, and banks deduct TDS above a threshold. Tax on FD interest and TDS on FD interest, Form 15G and 15H set out how.
5. Think about the emergency fund. The reason this hurts is that the money was not in the right place. An emergency fund kept in liquid assets avoids the problem; an FD ladder reduces it by maturing a slice at regular intervals.

The same logic applies to other lock-ins

Penalties on early exit are not a bank peculiarity. A mutual fund's exit load is the same idea in a different form; exit load break-even shows how to work out when waiting is worth it. The principle is the same: measure the penalty against the whole balance and the time left, not as a bare percentage.

Reading this

• The 7% rate, the 0.5% and 1% penalties and the loan margin are assumptions for the arithmetic, not any bank's terms.
• Annual compounding is used for simplicity; actual FDs usually compound quarterly.
• This describes how the cost is calculated. It is not a recommendation to break, keep or borrow against any deposit.