Fixed deposits or FDs are one of the most popular savings options in India. And, for good reason, they are great for conservative investors who are looking for a low-risk, low-cost savings avenue that will give them assured returns. On the other hand, FDs are also great for aggressive investors who are looking for low-risk options to diversify their portfolios.
So, regardless of whether you’re comfortable with taking risks or have a rather low-risk appetite, it’s worth exploring FDs. But, before that, it’s important to understand how they work. Understanding how FDs are calculated will help you optimize your FDs.
How do FDs Work?
When you open an FD account with any bank or financial institution, you’ll be required to make a one-time lump sum payment. This will be your initial deposit. This amount will accrue interest at a predetermined rate of interest, for a specified period of time. The time horizon is known as the FD tenure.
Financial institutions will often offer different interest rates depending on the tenures and deposit amount. Senior citizens can also get an additional interest rate of 0.25% to 0.65% when they save into an FD.
Depending on the way in which the interest is paid out, there are two types of FDs.
- Cumulative FDs
With a cumulative FD, the interest you earn on your deposit will be reinvested into your FD account until it matures. Upon maturity, you’ll receive both your initial deposit as well the accrued interest.
Cumulative FDs are a great option for you if you’re not too particular about getting a periodic interest income but would rather get a larger final payout.
- Non-cumulative FDs
With a non-cumulative FD, the interest accrued is paid out in regular installments as specified by you. This can be yearly, half-yearly, quarterly and even, monthly. Since your interest amount is paid out regularly, you’ll only get the initial deposit upon maturity.
Non-cumulative FDs are a great option if you prefer regular interest payouts over a lump sum payment upon maturity. This kind of FD is generally preferred by senior citizens as a regular source of income.
How is Interest Calculated on FDs?
Now that we’ve looked into the different types of FDs, the next order of business is to understand how they’re calculated. There are two types of calculation methods that are used to calculate interest on FDs, namely simple and compound interest.
- Simple Interest
Simple interest is a type of interest calculation method where the interest is calculated on the principal deposit amount. It doesn’t realize the benefits of compounding, where you will be able to earn interest on the interest accrued as well, thus maximizing your earning potential.
Simple interest = (P x R x T) ÷ 100
Where P is the principal amount, R being the rate of interest per annum and T is the tenure in years. Here’s an example to help you understand simple interest calculation a little bit better:
Let’s assume that you deposit ?5,00,000 for a period of 1 year, at 5% interest per annum.
Simple interest – (P x R x T) ÷ 100
Here,
= (5,00,000 x 5 x 1) ÷ 100
= 25,00,000/100
= 25,000
Hence, you’ll earn ?25,000 as interest on your FD if your financier employs simple interest calculation. Note that simple interest calculations are usually used to calculate non-cumulative FDs.
- Compound Interest
Compound interest refers to the interest that you earn on your accrued interest. This calculation method makes use of the power of compounding, which can help you earn higher returns on your savings.
Compound interest = P {(1 + i/100)t – 1}
Where P is the principal amount, i is the rate of interest per period and t is the tenure.
Let’s take a look at an example to help you understand compound interest better. Let’s suppose that you save ?5,00,000 into an FD for a period of 5 years and the rate of interest is 6% per annum.
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
Hence, you’ll earn ?1,69,112 as interest at the end of 5 years when you calculate using compound interest. Generally, financiers will use this method of calculating interest to ascertain the interest earned on cumulative FDs.
While these calculations seem simple enough, it may not always be possible to manually calculate the interest earned on FDs. For this reason, many platforms have an online FD calculator. All you need to do is enter in your savings amount, interest rate and tenure to arrive at your maturity amount and interest amount. Make sure to enter in the right figures to get accurate results.
Online FD calculators can also help you plan your finances better. You can tweak the FD amount, interest rates or tenure to understand how these things can impact your earnings. Depending on these learnings, you can tailor your financial decisions to suit your goals and needs.