FD Investment: How does compounding work? How much will ₹2 lakh investment become in 3 years? Explained

Fixed Deposit Investing Hacks: At a time when markets remain volatile, fixed deposits continue to pay stable interest rates to depositors, making them a popular investment tool among risk-averse people. FDs are largely immune to market volatility, and investors can rest assured that the FD interest rates with which they invested their money will not change even if the bank revises these rates later. FD investors continue to enjoy a fixed interest rate once they put their money in.

However, to make fixed deposits more alluring and beneficial, there are ways to maximise your gains. Most fixed deposits in India leverage the power of compounding to ensure maximum benefit.

Understanding how interest on fixed deposits is compounded helps you maximise returns through strategic planning, tenure selection, and choosing the correct institution as per your requirement.

What is FD compounding?

Compounding in fixed deposit is a powerful tool that truly enhances the essence of investing in an FD. A compounding fixed deposit is a type of FD where the interest earned is added to the principal amount at regular intervals, including yearly and quarterly, and the future interest is then calculated on this increased principal.

Over the years of the tenure of your FD, the compounding effect can exponentially grow your wealth. Unlike simple interest, where the principal amount remains the same, FD compounding accelerates your deposit at a higher rate.

How does FD compounding work?

As explained above, FD compounding works by factoring in a hiked principal every year or quarter. The interest is calculated on the hiked amount.

The compound interest formula for FDs is:

A = P (1 + r/n)^(nt)

Where:

• A = Maturity amount
• P = Principal (initial deposit)
• r = Annual interest rate (in decimal)
• n = Compounding frequency (usually 4 for quarterly)
• t = Time period in years

How much will ₹2 lakh investment become in 3 years?

To understand FD compounding better, let's take a closer look with example.

Suppose you want to invest an amount of ₹2 lakh for a period of three years in an FD with an interest rate of 6% compounded yearly. This ₹2 lakh is your initial principal amount.

After one year, the interest earned at 6% per annum will be ₹12,000. The principal at the end of year 1 will be ₹2,12,000.

After the second year, the interest earned on ₹2,12,000 will be ₹12,720. The principal at the end will be ₹2, 24, 720.

At the end of year three, the interest you will earn on this increased amount is ₹13,483. The final amount will be ₹2,38, 203.

Therefore, your original deposit of ₹2 lakh will turn into ₹2,38,203 at the end of three years.

Benefits of investing in a compounding fixed deposit

• Higher returns: Compounding FDs give you higher interest rates as compared to FDs that are calculated on the basis of simple interest.
• Security: FDs are one of the most secure forms of investments as they do not sway with the markets.
• Flexible compounding options: Most banks offer different compounding frequecies such as monthly, quarterly and yearly.