Higher EPF Returns Could Mean That You Pay More In EMIs

In election season, textbook economics goes for a longish holiday. Nothing else can explain how the Employees' Provident Fund Organisation (EPFO) could hike the interest rate it pays on deposits, when the RBI has cut its key rates. Of course, voters have no reason to complain. 

There is a good ethical reason to pay high rates to provident fund subscribers. For most people with salaried jobs EPF contribution is mandatory. They don't have a choice. EPFO rules allow withdrawals only under specific circumstances. In general, about twelve per cent of your basic pay gets locked up in forced savings till the time you hang up your boots. 

Since you cannot decide how to spend or invest that money, justice demands that you get a good and assured return on it. That is one reason why EPFO rates are typically higher than what you can get from other long-term fixed deposits. Even if a bank offers better fixed deposit rates, remember that unlike other bank deposits, your EPF savings are tax-free. 

Imagine that you have put Rs 10 lakh in a fixed deposit at an annual interest rate of 10%. At the end of the year Rs one lakh will be added to your account. Given that you could save so much, it is likely that you would be in the 30% tax bracket. That means out of the Rs one lakh, about Rs 30,000 will be taken away as tax. In effect, the interest you earned is Rs 70,000. And, the effective interest rate was 7%. If you had put in the same amount in your EPF account, even at the lower rate of 8.65%, you would have received a net return of Rs 86,500, because it would be entirely tax-free.

This difference is significant enough when you take just one year. It is massive when you compound it over a 20-year period. Rs 10 lakh saved in a fixed deposit at 10% interest annually would turn into Rs 38,70,000 post tax. The same amount deposited with EPFO at 8.65% would have yielded Rs 52,22,000. That's the power of compounding.

However, while this is very good news for the six crore EPF contributors in India, bankers will not be happy. Banks make money by lending it to you and me. They get that money from the deposits we make into the banks. They pay us interest on our deposits and charge interest on the loans we take. The difference between the two is the source of a bank's income. 

When the economy isn't doing too well and there aren't many takers for loans, banks park their excess cash with the RBI and earn interest on it. When the demand for loans increases, banks borrow from the central bank to meet it. When the RBI cut its key interest rates it did two things. One, it made it cheaper for banks to borrow from it, and two, it made it less attractive for them to park their extra cash. Both of these work as incentives for banks to lend more.

But loans face the same supply-demand pulls that any other good in the market does. If banks have more money to lend they are forced to reduce interest rates to attract borrowers. They can also afford to reduce the interest they pay to depositors, because they don't need that much cash any more. 

The trouble is that India's deposit growth has been very low. In 2017-18 bank deposits grew by just 6.7%, the lowest in 55 years. The latest data shows that credit growth has far outpaced deposit growth in this fiscal as well. Bankers fear that if they cut the interest rate, deposit growth might fall even further. And if they cannot lower deposit rates, they won't be able to lend cheaper. That is why, even after the RBI has cut rates, your EMIs haven't gone down. 

The RBI, under its government-friendly governor, is trying its best to prod bankers to pass on its rate cut, but the latest EPFO rate hike will make the central bank's task more difficult. Any salaried employee can voluntarily put in their entire basic pay and dearness allowance into their EPF to take advantage of the higher rate. That means the EPFO could potentially suck out a big chunk of household savings that could have otherwise gone into the banking system. The only way banks can attract more money is by increasing interest rates on deposits. But higher deposit rates increase a bank's cost of funds, which, in turn, makes it tough to give cheaper loans. 

There's extra demand for credit coming from the government as well. It is set to borrow more to meet the additional spending it is scheduled to do this year and in the next fiscal. Bankers and bond traders say that the jump in government borrowing will keep bond yields high. That means savers will have more attractive debt instruments available to them than a simple fixed deposit. This is yet another reason why banks will find it tough to cut deposit rates and lower lending rates. 

So, here's the thing to remember. When the EPFO pays you more on the mandatory deduction from your salary, you might end up paying more in terms of EMIs. To top it, you will enjoy the benefits of a higher EPF interest rate only after you retire, you will feel the pain of higher EMIs right now.

(Aunindyo Chakravarty was Senior Managing Editor of NDTV's Hindi and Business news channels. He now anchors Simple Samachar on NDTV India.)

Disclaimer: The opinions expressed within this article are the personal opinions of the author. The facts and opinions appearing in the article do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.