The answer is no. As a depositor, you need to understand the difference between the rate of interest, annualised yield and effective annualised yield for various tenures often highlighted by the banks. The rate of interest on fixed deposits mentioned by the bank is usually the return offered on the principal amount where interest is compounded quarterly. It does not include any other factor.
For example, this bank offers an interest rate of 8.1 per cent for a fixed deposit tenure of three to five years for deposits below Rs 2 crore. Let us assume that you invest Rs 1 lakh for five years. Since the interest rate on FD is compounded quarterly, 2.02 per cent (i.e., 1/4 of 8.1 per cent) of Rs 1 lakh is added at the end of the first quarter. So, the principal amount of the fixed deposit goes up to Rs 1,02,025 at the end of the first quarter. Similarly, 2.02 per cent of Rs 1,02,025 is added at the end of the second quarter and this process continued till the end of one year is complete. The initial investment value of Rs 1 lakh grows to Rs 1,08,349 at the end of the year, which is higher than the amount Rs 1,08100 which we would have got after adding simple annual interest of 8.1 per cent.
Do remember the annual yield per annum is 8.35 per cent which is slightly higher than the interest rate 8.1 per cent quoted by the bank due to quarterly compounding. So the interest gets added to the principal every quarter which means your principal amount increases quarterly.
| How annual yield is calculated for 8.1% | |||
| Quarter No. | Principal after quarterly compounding | Quarterly Interest Earned (8.1%/4) | Annual Yield (%) |
| 1 | 100 | 2.03 | |
| 2 | 102 | 2.07 | |
| 3 | 104 | 2.11 | |
| 4 | 106 | 2.15 | 8.35 |
| For rate of interest 8.1% p.a. | |||
However, the bank shows the effective annualised yield as 9.86 per cent and 12.30 per cent for FD with five-year and ten-year tenures respectively. The bank also mentions that the effective annualised yield is calculated on the assumption of quarterly compounding frequency and for the highest tenure in each slab. How does the bank arrive at this 12.30 per cent figure for the 10-year fixed deposits when the rate of interest is 8.1 per cent per annum?
Let us understand this with a smaller tenure of 5 years. To get the effective annulised yield, such banks calculate the return on maturity based on a simple interest rate. This makes it appear to the investors that the principal amount remains constant throughout the entire tenure of your fixed deposit while you earn higher effective annualised yield. As you can see, this is not the case. In the below-mentioned example, the total return after five years will be Rs 1,49,325. Since this is an absolute return of 49.32 per cent, banks divide this value by 5 years to arrive at the 9.86 per cent effective annualised yield.
The best way to compare return rates between two financial products is CAGR. The Securities and Exchange Board of India (Sebi) has made it mandatory for mutual funds to use CAGR while giving their historical returns. The compound annual growth rate (CAGR) for a 5-year FD (with an 8.1 per cent interest rate) will only be 8.35 per cent and not 9.86 per cent as projected by the bank.
Similarly, the amount of interest earned in 10 years goes up to Rs 1,22,979 which is an absolute return of 122.98 per cent, these banks divide it by 10-year period to get an effective annual yield of 12.30 per cent, which is nothing but a average simple interest rate only if you keep your FD locked for 10 years.
| Misleading way of higher effective annual yield | |||
| Quarter No. | Principal after quarterly compounding (Initial principal (P) = Rs 1 lakh) (Rs) | Quarterly interest earned at 8.1% rate (Rs) | Annual interest earned (Rs) |
| 1 | 1,00,000 | 2,025 | |
| 2 | 1,02,025 | 2,066 | |
| 3 | 1,04,091 | 2,108 | |
| 4 | 1,06,199 | 2,151 | 8,349 |
| 5 | 1,08,349 | 2,194 | |
| 6 | 1,10,543 | 2,239 | |
| 7 | 1,12,782 | 2,284 | |
| 8 | 1,15,066 | 2,330 | 9,046 |
| 9 | 1,17,396 | 2,377 | |
| 10 | 1,19,773 | 2,425 | |
| 11 | 1,22,199 | 2,475 | |
| 12 | 1,24,673 | 2,525 | 9,802 |
| 13 | 1,27,198 | 2,576 | |
| 14 | 1,29,773 | 2,628 | |
| 15 | 1,32,401 | 2,681 | |
| 16 | 1,35,082 | 2,735 | 10,620 |
| 17 | 1,37,818 | 2,791 | |
| 18 | 1,40,609 | 2,847 | |
| 19 | 1,43,456 | 2,905 | |
| 20 | 1,46,361 | 2,964 | 11,507 |
| Total interest in 5 years (E) | 49,325 | 49,325 | |
| Per year interest (e=E/5) | 9,865 | 9,865 | |
| Simple interest rate {I=(e*10)/P} | 9.86% | 9.86% | |
Interest rate is compounded quarterly
How banks are calculating effective annualised yield for a 10-year FD
Principal amount(P) = Rs 1,00,000
Interest rate= 8.1 per cent per annum compounded quarterly
Return on maturity = Rs 2,22,979.09
Total interest in 10 years (E)= Rs 1,22,979
Per year interest (e=E/10) = Rs 12,297.9
Effective annualised yield highlighted by banks {I=(e*10)/P}= 12.3%
Hence, applying the simple interest formula to a compounding investment is misleading. It is obvious that if you keep your money for a long period, the total return on maturity will be high. The higher amount after maturity might appear as if you have earned a higher rate of interest.
FD depositors: Be careful
To make their product look better than their competitors, some financial institutions mention annualised yield on their websites. Now mentioning annualised is not an issue. However, calculating effective annualised yield based on simple interest instead of compound interest is the main problem. The longer the tenure, higher this would appear despite the underlying interest rate remaining the same. So don’t get fooled by the higher annualised yield on deposits while booking your fixed deposit. You should talk to the bank and understand how much return you will get at the end of maturity before investing.