How the frequency of compounding works to generate higher returns from bank fixed deposits?

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How the frequency of compounding works to generate higher returns from bank fixe
Bank fixed deposits, the most famous investment option among the conservative or risk-averse investor class, yields higher return based on the frequency of compounding. So, other than the usual parameters which the investors pay heed to while investing in a fixed deposit of interest rate and the tenure, customers should also know about the compounding frequency. The same can be known either by the bank representative or can be checked from the bank website

Also, with the notification put in place by the RBI, banks backed by the core banking platform are allowed to pay interest rate on both the bank fixed deposits as well as saving accounts even before the end of the quarter.

How compounding frequency increases returns on bank fixed deposits?

In a general case, when despite the allowed provision by the RBI wherein banks can now provide interest on deposits at a shorter term of less than three months or a quarter, banks have hardly implemented the case and in turn offer interest on the term deposit every quarter. And this computed interest is reinvested to include in the principal amount for the next quarter. So, greater is the frequency of compounding, interest amount added to the principal amount for reinvestment increases in the same proportion.

The proposition can be explained using an illustration. For instance, in case you invest in an FD worth Rs. 50,000 for an year at an interest rate of 9.00% per annum. The more frequent is the compounding, higher are the returns generated over the tenure of the deposit. Assuming the bank compounds interest on a half-yearly basis, an investor in the FD shall be able to reap a total of Rs. 4601.25 ( Rs. 2250 in the first half and Rs. 2351.25 in the second half over the maturity term of the deposit) as interest on the investment. And where the compounding is done quarterly, a higher amount of Rs. 4654.16 will be realized by you in comparison. For a longer FD term, the difference in return shall be substantial.

So, make it a point to even take note of the compounding frequency, before locking in funds in the bank fixed deposit scheme to realize a comparably higher return.

Story first published: Tuesday, March 25, 2014, 13:04 [IST]
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