An advertisement by DCB Banks struck me. It said its offering 9.25% annualized yield on a 36 months fixed deposit. The advertisement surely drew my attention and I am sure it was for many people looking for high interest rates from fixed deposits. Unfortunately, as it happens if it seems too good to be true it is not! What the bank has mentioned it the “annual yield” and not the interest rates. I know this may sound confusing as most do not know the difference between interest rate and Yield. In this post we explain both and show the difference by example.
Interest Rate on FD:
If we take the above example of DCB Bank, it offers 8.25% interest on its 36 month FD. The interest is compounded quarterly. The interest we are talking about is compound interest.
If we deposit Rs 1 Lakh for 36 month at 8.25% interest compounded quarterly, below is how the calculation would look:
|Year 1||Quarter 1||2,063||1,02,063|
|Year 1||Quarter 2||2,105||1,04,168|
|Year 1||Quarter 3||2,148||1,06,316|
|Year 1||Quarter 4||2,193||1,08,509|
|Year 2||Quarter 1||2,238||1,10,747|
|Year 2||Quarter 2||2,284||1,13,031|
|Year 2||Quarter 3||2,331||1,15,362|
|Year 2||Quarter 4||2,379||1,17,742|
|Year 3||Quarter 1||2,428||1,20,170|
|Year 3||Quarter 2||2,479||1,22,648|
|Year 3||Quarter 3||2,530||1,25,178|
|Year 3||Quarter 4||2,582||1,27,760|
At the end of 36 months (3 years) you would get Rs 1,27,760. The interest we gained was Rs 27,760.
Yield on FD:
How to we calculate the yield on fixed deposit? Its simple, we divide the total interest gained at the end of tenure and divide it with the (number of years * principal amount).
In our case above the yield would be = 27,760/ (1,00,000 * 3) = 9.25%
This is how the advertisement shows 9.25% instead of 8.25%. If you look carefully annual yield is nothing but Simple Interest. The advertisement is showing you simple interest instead of compound interest!
Why is Yield not a Good Metric for FD?
If we take the above example, the same interest can have different yield depending on the tenure of investment. The longer the investment duration the higher would be the yield.
The table below shows yield for 8.25% interest (compounded quarterly) on 1 to 10 years investment for Rs 1 Lakh investment.
Only yield does not tell you what percentage interest you get until you know the tenure.
When can Yield be used?
There are cases when yield can be used for comparison. One case would be when you want to compare fixed deposit with same tenure but having different interest rate and different compounding frequency.
For e.g. which of the 2 is better investment option in terms of return?
- Rs 1 Lakh invested @ interest rate of 8.50% compounded annually for 2 years vs
- Rs 1 Lakh invested @ interest rate of 8.25% compounded quarterly for 2 years vs
In the first case the interest would be Rs 17,723 while in the second case the interest would be Rs 17,742. The yield would be 8.86% Vs 8.87% respectively.
Helpful Posts on Fixed Deposits
Interest Vs Annual Yield on FD:
I hope now you have clear understanding of interest vs yield that is advertised by banks on their FDs. Do not be fooled by such misleading numbers and Never compare an one bank’s yield on FD with other bank’s interest rate. Do your own calculation before investing.