Fixed Deposits: Power of Compounding, Interest Rate Frequency and Yield

Fixed deposits are considered to be one of the most simple investments – easy to understand and not may complicated terms and conditions. But as all other investment products have increased in complexity with time, so have fixed deposits. There are few terms which you should know and this will help you to calculate your returns more accurately and wont’t feel cheated after the investment is made.

Compound VS Simple Interest:

This is easy and most of us have studied this in our basic Maths class. Keep in mind at same interest rate compound interest rate would grow much more than simple interest. Below is the graph showing how Rs. 1 Lakh would grow in 25 years with interest rate of 10% per year simple and compound.

As you can see compounding follows in exponential curve while simple interest returns increase linearly. The returns are more and more discriminating with increasing time period.

The reason why compound interest rate grows much more is because in compounded you get interest on your interest while in simple interest you get interest on your initial investment only.

Now Compound interest rate varies depending on frequency on compounding. The compounding can happen yearly, Half yearly, quarterly, monthly or even daily.

Compounding Frequency:

Below is the graph showing how your investment of Rs 1 Lakh would grow in 10 years at 10% interest if you have yearly, Half yearly, quarterly, monthly and daily compounding.

As you can see the difference in returns is not very huge but, its important for you to know whats the frequency of compounding on your investment.

Yield:

This term existed from always but has recently become very popular and is mentioned in almost all the fixed deposit/ bonds advertisements. Yield is the total benefit you derive from investing in scheme at a certain cost.

Yield will include the benefit of compounding as well as any tax benefit you derive from the investment but after deduction of any tax payments on the interest.

Below is the chart showing yield in case of above investment at different compounding frequency.

Cumulative vs Pay-out:

This is an option in most of the bonds and confuses investors. If you choose cumulative option the entire sum would be paid at maturity and so magic of compounding works here. In case of payout the interest gained is regularly paid back to investor at frequency opted out by him. This is good for investors looking for regular income while cumulative option is suited for someone looking for long term wealth creation.

So go ahead and the choose the Fixed Deposit which suits you!