Fixed Deposit - Interest calculation procedure

A Fixed Deposit can be defined as an investment in which you deposit your money in a Bank for a fixed lock-in period. In return, the Bank gives you an interest at a specified rate and that interest is added to the original deposit while paying the accumulated amount to customer at the time of maturity.  Banks also give you the option of periodic pay-outs in the form of monthly and quarterly interest payments if you intend to use that interest as a source of regular income.

You can save any amount in a Fixed Deposit starting from Rs.10,000/- without any upper cap for a lock-in period of 7 days to 10 years. Some banks may also offer fixed deposits where the minimum amount may be lower.

 Interest on Fixed Deposits and its calculation

Banks offer both fixed and floating rate of interest. Fixed rate of interest is unaffected by any change in market rates and stays constant during the deposit term. On the other hand, floating interest rates vary as per the market rates and keeps changing throughout the deposit term.

For any fixed deposits below 6 months, Banks use simple interest while paying the sum at maturity. While for any deposits above 6 months in tenure, the interest is calculated using compound interest and it is compounded quarterly.

For the sake of understanding how Compound Interest which is compounded annually works, let us a simple example -

Assume you invest Rs 1000 for three years at 10%, compounded annually. Here is how the interest is calculated –

Year 1: Interest is 10% of Rs 1000 – Rs 100

Year 2: Your investment amount now is Rs 1100 ( Rs 1000 + Year 1 interest)

Interest is10% of Rs 1100 – Rs 110

Year 3: Investment amount is now Rs 1210 (Rs 1000 + Year 1 interest + year 2 interest)

Interest for year 3 is 10% of Rs 1210 – Rs 121

Total Interest for 3 years: Rs 100 + Rs 110 + Rs 121 = Rs 331

Amount – Rs 1000 + Rs 331

That gives you a fair idea how Compound Interest works. Now, when it comes to compound interest on Bank Fixed Deposits, the compounding is done quarterly.

Here is a simple formula to illustrate how it is calculated –

Let us consider the following values –

P (Principal) = 50000

R (Rate of Interest) = 9% or 9/100 or 0.09

n (compounding period) = 4

Since most Banks compound interest on a quarterly basis, we use n as 4 within the above equation to calculate annual interest and maturity amount. Similarly, if the interest compounding takes place semi-annually or monthly, the value of the compounding period becomes 2 and 12 respectively.

t (number of years or lock-in term) = 2

Inputting the values, the equation becomes

A (Amount on Maturity) =   50000 (1+0.09/4)4*2 = 59500/-

So interest is Amount – Principal = 59500-50000 = 9500/-

For better gains, it is recommended that you opt for reinvestment of interest within the fixed deposit.

Types of Fixed Deposits

The two types of fixed deposits are:

1)      Bank Fixed Deposits

2)      Corporate fixed deposits

While Bank Fixed Deposits are made with Banks, Corporate Fixed Deposits are made with companies who are looking for people to invest and fund their business.

Corporate deposits do offer a slightly higher interest rate but the level of risk is also higher. In addition, corporate deposits do not have the liquidity that Banks deposits offer and the lock-in periods will not have the same level of flexibility as available in Banks.

Tax Benefits on Fixed Deposits

Banks also offer Tax Saving Fixed Deposits as per the provision under section 80 C where the lock-in period is 5 years. Say, you have invested 1,00,000/- in a tax saving fixed deposit for 5 years. As per the provision released by the Government, you get tax benefit as per your income slab.

If you fall in the 30% income slab, you get a benefit of 30,900 bringing the effective investment down to 69,100/-. Similarly for 20% and 10% income slabs, the benefits will be 20,600/- and 10,300/- respectively.

However, the interest earned on the Fixed Deposit during a financial year is taxable and there is also ‘tax deducted at source’ when the interest is reinvested for the next year.You should also note that as an individual, you can invest the maximum amount of 1 lakh in a year.

Advantages of investing in Fixed Deposits

• Negligible risk
• Assured Returns
• Capital Appreciation
• Flexibility of parking additional capital for small terms
• Tax benefits for 5-year deposits

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