How to determine how long your term deposit should be by converting interest rates

Following on from How to earn more interest and pay less tax on your term deposit, deciding how long your term deposit should run for depends on a number of factors.


Firstly, you need to be able to compare different term deposit rates. Because interest rates are always changing, it is difficult to compare 3 months at x% (which could then be reinvested 4 times) versus 1 year at y% (paid on maturity). But below is how to find an equivalent rate.


Converting from x months to a yearly rate

To convert the interest rate from x months to a yearly rate, you can use this formula:

1 + interest rate divided by (12 divided by months) to the power of (12 divided by months) – 1


How to convert a 3 month term deposit to the equivalent yearly rate

So to convert a 3 month term 3.80% term deposit to the yearly rate you would get:

1+0.038 divided by (12 divided by 3 = 4) to the power of (12 divided by 3 = 4) – 1 = 3.85%

Or copy this formula into excel = (1+A1/(12/B1))^(12/B1)-1, where A1 is the interest rate and B1 is the number of months.

All things being equal, a 3 month term deposit earning 3.80% and rolled over with the interest for 4 quarters would provide the same cash at the end of a year as a 3.85% yearly term deposit where the interest is paid on maturity.


Factors to consider when setting the period of your term deposit


Likelihood that you will need the money

If you think you will need to cancel the term deposit, then don’t lock it away for a long period.

Any small benefit from a longer period term deposit may be wiped out by cancellation fees if you need to cancel the term deposit early.


Whether the bank offers an incentive for longer term deposits

Some banks offer the equivalent rate for yearly and shorter periods. If a bank offers a rate that (if compounded) is the same as the yearly rate, you might choose the shorter period if there is a chance you might need your money, or you might choose the longer period to defer the tax into the next year (if applicable).


Hassle of rolling forward the term deposit

One benefit for choosing a longer period is avoiding the hassle of having to advise the bank to roll forward your term deposit regularly (as when you pick shorter periods). Otherwise you might be stuck with the cash rate if you haven’t taken appropriate action by the rollover date.


What you suspect interest rates will do in the future

You might have an idea where interest rates are going, but so do banks.

The banks change their interest rates according to how much they want your deposits and what the reserve bank interest rate is. If you suspect interest rates will go up, hopefully the banks will offer higher interest rates for longer periods.


Tax implications

Interest is taxed when the cash is paid (rather than as it accrues). See my previous article about this. What this means is any interest paid on or after 1 July will be taxed next year.


My conclusion

A shorter term deposit is going to give you a lower rate and mean you are less likely to cancel your term deposit if you need the cash. But banks realise that compounding more often means more interest for you, so they often reduce the rates offered where the term is less than a year.

Having a long term deposit might mean deferring tax, but it also might mean you have to pay more in one go when you lodge your return.

Posted in Making Money, Saving Money

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