BackDe-jargoned: Fixed deposit interest rate calculation
Don't simply look at the interest rate and the duration, but also at the frequency of compounding
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Fixed deposits (FDs) are considered one of the most popular financial instruments in India. For years, we have been investing in FDs. But do you know how banks calculate returns?
Interest rate calculation
In its policy document released on 29 October, the Reserve Bank of India (RBI) decided to give banks the option to pay interest on savings and FDs at intervals shorter than a quarter as most of the banks are now on the core banking platform. At present, banks pay interest on FDs quarterly or at longer intervals. As of now, none of the banks have come up with shorter intervals considering that RBI has left it to them to decide. Here is how the math is done for FDs.
Say, you have invested 1 lakh in an FD at an interest rate of 8% per annum. Let’s look at three different options. In option 1, the interest earned is reinvested half yearly in a one-year FD. In option 2, interest will be reinvested every quarter at 8% per annum. In option 3, interest will be reinvested every month. If you pick option 1, at the end of five years, you would have earned 48,024 on the principal. In the first six months you will earn 4,000, by the end of the first year 8,160, and so forth. If you pick option 2, at the end of five years, you would have an interest of 48,595 on 1 lakh. In option 3, where the interest is compounded monthly, you would have earned 48,985. And if the same amount is compounded daily at an interest rate of 8% per annum, you would earn 49,175 in five years. The more frequent the compounding, the higher the returns.
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The final amount that you get is based on the calculation of the principal amount, annual nominal interest rate, the number of times the interest is compounded per year and, of course, the number of years. Remember that interest for reinvestment is calculated every quarter by most banks, and the principal is increased to include interest earned during the previous quarter. You can do the same calculation by using different interest rates that various banks offer.
Don’t simply look at the interest rate and the duration while investing in an FD, but also at the frequency of compounding. Ask the banks about the compounding frequency. You can do this by simply checking the bank website or through the bank’s call centre. Banks generally calculate FD on a quarterly compounding basis, but for deposits with tenors below six months, the interest is mostly calculated at maturity as simple interest.
As the calculation above shows, the amount that you will receive depends a lot on the compounding frequency. If you do not want to do the math on your own, you could use any website that has an FD calculator available.
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