Out of all the investment tools available in India, the simplest one is Fixed deposit: (1) it’s the safest, and hence, a lot many would prefer it over other suitable option, (2) the calculations are really easy to do, thus, you know how much you can expect at maturity. However, even with such simple calculations involved, potential investors fail to leverage the readily available benefits. People presume the preconceived notion: a higher interest rate offered in a fixed deposit scheme is equal to higher profits; which is partially wrong – higher interest rate does play a crucial role in obtaining higher profits but the desired return on investment is only possible if the compounding frequency (the number of times interest is compounded for your investment in FD every year) is accordingly higher.
Let’s understand how compounding frequency makes the difference in your returns from the fixed deposit.
As per the currently available FD schemes, Fincare Small Finance Bank offers a whopping 9 percent return on investment (given the maturity period of FD should be 3 years). On the same hand, SBI – the biggest bank in the public sector, offers an ROI of 6.70 percent per annum for their 3 year FD scheme.
Let’s assume Ramesh and Suresh (fictional characters) invest a sum of Rs 50 thousand each in these schemes: Ramesh chooses to go with Fincare Small Finance Bank because of the higher interest rate (which is a very obvious move – anybody seeking higher profits will do as Ramesh) whereas, Suresh chooses to go with SBI. Now, let’s just assume there’s a condition – the FD scheme offered by Fincare Small Finance Bank is compounded once a year (just assumptions, the actual compounding frequency may be higher), whereas, the FD scheme by State Bank of India is compounded four times a year (quarterly compounded). Accordingly, Ramesh will get a maturity value of Rs Rs. 64751.45, in which the collective interest earned over the entire investment period of three years calculates to Rs 14751.45.
Moving on to Suresh, Suresh, from his FD investment with SBI gets a maturity value of Rs 61029.55, and the interest Suresh obtained from his investment turns out to be Rs 11029.55.
Now, the real question is, how does it make the difference? Ramesh eventually got higher returns as compared to Suresh! Given the interest difference which was approximately 2.30% per year, Ramesh was able to earn a 6.90% higher income as compared to Suresh. But, if Suresh had got the same interest rate as of Ramesh at SBI, he would have earned a maturity value of Rs 65302.50 wherein the interest would be 15302.50.
This is how compounding makes the difference in ROI from FD schemes.
Moral of the story:
1. Never ignore the potential benefits of compounding frequency. Banks – generally the ones in public sector, keep the compounding frequency to 4 times a year – the interest is compounded after every three months as per the applicable interest rate and added to the principal for next interest calculation. On the other hand, some financial institutions offer fixed deposit schemes wherein the interest is compounded only once a year which reduces the potential returns by a considerable percentage.
2. A higher interest rate is not the only thing, make sure to check the compounding frequency as well. If you find yourself confused between two FD schemes with a mere difference of 0.1 or 0.2 percent in the interest rates, check the compounding frequency. Use a fixed deposit calculator if need be to calculate the exact returns you can procure and make a smart decision.