Term Deposit (Fixed Deposit) & Interest
Term deposits are well known for the safety, liquidity and flexibility. Term deposit also known as fixed deposit allows a customer to lock in his deposit for a specific period at the interest rate prevailing at the time of opening of account (Fixed rate of interest). Recently, banks have started offering deposits with interest rates linked to external rates. Term deposit is the most popular investment option among Indians.
How can a customer withdraw interest on a Term Deposit (fixed deposit)?
As per RBI norms, methodology for calculation of interest on deposits can be decided by Banks. However, the manner of calculation of interest should be informed to depositors appropriately at the time of accepting the deposits. Interest should be displayed at branches. They have also freedom to offer floating interest rate linked to a transparent external benchmark. However, majority of banks are paying fixed interest rate on quarterly compounding basis. So when a bank announces that it will pay 8% interest p.a on a term deposit, it means that the bank will pay interest at 8% on quarterly compounding basis. This means that every three months, the interest will be paid on the total interest earned till the previous quarter too.
For example, if you invest Rs. 10,000 in a bank for 5 years, bank will credit interest of Rs. 250 into the account at the end of first quarter. In the second quarter, bank will be paying Rs. 250 plus interest at 10% for three months on the already earned interest of Rs. 250. Thus, the interest credited to the account for the second quarter will be Rs. 256.25. This is called compound interest. However, this compounding will be effective only if the deposit is maintained for more than three months as RBI insists compounding of interest only on quarterly (three months) period.
When a term deposit is made for a long period, the investor can decide whether the interest is to be withdrawn periodically or only at the time of maturity. The depositor can decide the frequency at which the interest is to be received, whether it should be received at monthly, quarterly, half yearly or annually. Term deposit also offers option to receive entire interest along with principal at maturity. Such deposits are called cumulative fixed deposits.
As mentioned above, a depositor can opt for withdrawing interest on monthly, quarterly, half yearly annually or at the time of maturity. If you opt to withdraw the interest on quarterly basis, you will be receiving exact amount of Rs. 250. But, if you withdraw on monthly basis, it will be slightly less than one third of Rs. 250, as bank is parting money before three month period, the minimum period required for compounding. The interest on interest (compounding effect) will be effected in the deposit only if the interest is retained in the deposit.
To understand the impact of compounding please read the article Compound interest- The reason to start saving today.
Which is the formula to be used for calculating interest on term deposit with banks?
The formula to be used for calculating maturity amount of the deposit is that for compound interest. This formula is applicable when the deposit for more than three months.
Maturity amount = P ( 1 + R / 100 x T )^ NT
Where
P- The principal amount
R- Interest offered by the bank
T- Number of times interest is calculated per year (4 for banks)
N-Total period of the term deposit
Based on this formula, for principal amount of Rs. 10,000 deposited for a period of 5 years at interest rate of 10% becomes Rs. 16,386. Thus, the effective interest rate becomes 10.38%. It must be kept in mind that when a bank offers deposit interest rate of 10% for 5 years and another bank offers effective rate of 10.38% for 5 year period, both are offering same rate. To avoid misleading customers, banks are advised by RBI not to advertise effective rate alone.
If the deposit is for three months or less, the formula to be applied for interest calculation is simple interest formula.
Simple Interest = Principal Amount x Interest Rate x Time period
