Fixed deposits or FDs are safe investment options that offer guaranteed returns in the form of interest on the amount deposited. Since the returns are not market-linked, FDs are ideal investment options for conservative investors who wish to earn assured returns on the amounts they invest. In addition to this, fixed deposits also help aggressive investors reduce the overall risk in their portfolios.
So, irrespective of whether you are comfortable or averse to taking risks, fixed deposits may be suitable for your investment portfolio. However, before you invest in a fixed deposit, you need to know how FDs work and how fixed deposit interest is calculated. This will help you better understand how to optimise your returns from FDs.
How do Fixed Deposits Work?
When you open a fixed deposit account with a bank, you will have to make a one-time lump sum investment in your FD account. This investment will be valid for a specified period, known as the FD tenor. Over this tenor, you will earn interest at a predetermined rate on the amount deposited in your FD account.
Banks offer different rates of interest for different tenors and investment amounts. For instance, the 1-year FD interest rates may not be the same as the rates for a tenor of 999 days, or a tenor of 5 years. You can compare the FD rates to identify the tenor that offers the highest returns.
Depending on when the interest earned on your FDs is paid out to you, there are broadly two types of fixed deposits, as outlined below.
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Cumulative FDs:
Here, the interest that you earn on your fixed deposit is reinvested in the account until the FD matures. So, you will receive the interest at maturity, along with the principal amount deposited.
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Non-Cumulative FDs:
Here, the interest earned on your FD is paid out to you at regular intervals instead of being reinvested in the account. So, at maturity, you will receive the last interest payout and the principal amount deposited.
A Closer Look at How Fixed Deposit Interest is Calculated
Depending on the type of fixed deposit, the interest can be any one of two types, namely simple interest or compound interest. Typically, when you opt for monthly interest payouts, you do not get the benefit of compounding and only earn simple interest on your FD. On the other hand, when you opt for a cumulative FD, the reinvested interest gives you the benefit of compounding over the FD tenor.
Let us take a closer look at how fixed deposit interest is calculated in both of the above scenarios.
Scenario 1: Simple Interest on Fixed Deposits
Simple interest is a type of interest that is calculated only on the principal amount of the deposit. It does not offer the benefit of compounding, where you earn interest on interest. The formula for simple interest is given below.
| Simple interest = (P x R x T) ÷ 100 |
Here, P is the principal amount, R is the rate of interest per annum and T is the tenor in years.
Let’s take up an example to understand this better. Say you invest ₹5 lakhs in an FD for a period of 1 year. And the 1-year FD interest rate is 5% per annum. In that case, the simple interest on the FD will be computed as follows:
Simple interest:
= (P x R x T) ÷ 100
= (5,00,000 x 5 x 1) ÷ 100
= 25,00,000 ÷ 100
= ₹25,000
Scenario 2: Compound Interest on Fixed Deposits
Compound interest is essentially interest earned on interest. The formula for computing compound interest is given below.
| Compound interest = P {(1 + i/100)t – 1} |
Here, P is the principal amount, i is the rate of interest per period and t is the number of periods of compounding.
So, let’s again take an example to understand how fixed deposit interest is calculated in the case of compound interest. Say you invest ₹5 lakhs in an FD for a period of 5 years. And the 5-year FD interest rate is 6% per annum, compounded annually. In that case, the compound interest on the FD will be computed as follows:
Compound interest:
= P {(1 + i/100)t – 1}
= 5,00,000 {(1 + 6/100)5 – 1}
= 5,00,000 {(1.06)5 – 1}
= 5,00,000 {(1.338 – 1}
= 5,00,000 x 0.338
= ₹1,69,112
Conclusion
Now that you know how fixed deposit interest is calculated, you can make a more informed decision about which FD to invest in. Remember to take the appropriate interest rates for your calculation, because the 1-year FD interest rates can be different from 5-year FD interest rates, and so on. Also, ensure that you use the right investment tenor and investment amount in your computation, so you can get accurate results.
To create an appropriate investment plan for your future, you can compare the fixed deposit interest you will earn over different tenors, at varying interest rates. You can then identify the right FD option for your portfolio and make your investments accordingly.
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