Fixed Deposit Interest: How Compounding Changes What You Earn

Two banks offer a fixed deposit. One advertises 7.00% and the other 6.95%. The first looks better, but the second may pay you more, because the headline rate says nothing about how often interest is added to your balance. That one detail, called compounding, is the reason fixed deposit offers are hard to compare by eye.

What a fixed deposit actually pays

A fixed deposit (FD, or term deposit) locks a sum with a bank for a fixed period at a stated yearly interest rate. At the end you receive the maturity value: your deposit plus the interest it earned. Unlike a savings account, the rate is agreed up front and does not move during the term.

The stated rate is a nominal rate. Banks normally add the interest to your balance several times a year, and from then on the interest itself earns interest. The more often this happens, the more you end up with, even though the nominal rate is the same.

The same 7% at five different frequencies

Here is a deposit of ₹1,00,000 at 7% a year for 5 years, calculated with the FD Calculator.

Simple interest is the odd one out: it is worked out on the original deposit only, so the earnings are the same every year. The four compounding options differ by only ₹1,508 over five years on this amount, but the gap grows with a larger sum or a longer term.

Effective yield: the number to compare

The effective yearly yield turns any compounding pattern into the single yearly rate that would give the same result if interest were added once a year.

• 7% added yearly is 7.000% effective.
• 7% added half-yearly is 7.122% effective.
• 7% added quarterly is 7.186% effective, which is why a quarterly FD at 7% beats a yearly one.
• 7% added monthly is 7.229% effective.

Use effective yield whenever offers compound differently. Take a deposit of ₹5,00,000 for 3 years. An offer of 6.5% compounded monthly has an effective yield of 6.697% and matures at about ₹6,07,336. An offer of 6.6% compounded yearly has an effective yield of exactly 6.600% and matures at about ₹6,05,678. The lower headline rate wins by roughly ₹1,658.

The formula behind the numbers

For compound interest, the maturity value is A = P × (1 + r ÷ n)^(n × t). P is the deposit, r the yearly rate as a decimal, n the number of times interest is added per year and t the number of years. For quarterly compounding n is 4, so ₹1,00,000 at 7% for 5 years is 1,00,000 × (1 + 0.07 ÷ 4)^20 = ₹1,41,478.

The calculator also accepts periods that are not whole years. A 18-month deposit at 7% compounded quarterly matures at about ₹1,10,970. Banks sometimes count days, so their certificate can differ from the calculator by a small amount; the bank's figure is the final one.

What the headline number leaves out

Several things change what you actually keep, and none of them is in a simple maturity calculation.

• Tax. Interest on a deposit is generally taxable, and banks may deduct tax at source above certain limits. The interest shown is before tax.
• Early withdrawal. Breaking a deposit before maturity usually earns a lower rate and may carry a penalty.
• Rates for different customers. Banks often offer a higher rate to senior citizens and different rates for different terms.
• Inflation. A 7% return with 6% price rises is a small real gain. The Inflation Calculator shows what a fixed sum will buy later.

A simple way to compare offers

1. Write down the nominal rate, the term and how often interest is added for each offer.
2. Enter each one in the FD Calculator with the same deposit and read the maturity value and the effective yield.
3. Prefer the higher maturity value for the same term and amount. If the terms differ, compare the effective yield and think about when you will need the money.
4. For money you will add to every month, use the SIP Calculator or the Compound Interest Calculator instead, because an FD is a single lump sum. Simple vs compound interest explains why the difference grows with time.