- Understanding Compounding and How it Works
- Types of Compound Interest
- Availing Compound Interest Benefits on Fixed Deposits
Fixed deposits have been around for decades and are a favourite among Indians. Their low-risk profile, guaranteed return, and a decent interest yield are what attracts investors. It is also a safe way to park money and earn interest on it as well. Almost every bank, NBFC, and other kinds of financial institutions offer the facility of investing in fixed deposits. However, the key to creating true wealth overtime with fixed deposit investments lies in the magic of compounding.
While most of us have studied simple interest and compound interest in our school days, as we grow up, the concept becomes alien to us. However, understanding compound interest and availing its benefits can help you build real wealth. Even while investing in fixed deposits is important to know whether your bank is offering interest at a compounded rate or on a simple interest basis.
If you are planning to invest money in a fixed deposit (or otherwise), this article is a short, crisp guide to understanding one of the key concepts of wealth building.
To understand compound interest, let’s have a look at how simple interest works. In simple interest, you get to earn interest, every year, on the principal amount only. For example, if you invested 10,000 rupees for a period of 5 years at a rate of 5% p.a., then you will earn a flat interest of 500 rupees every year.
In the compound interest method, the interest that you earn is added to the principal, and then you earn interest on the combined amount. Again, the interest earned is added to the principal, and then you earn interest on this combined amount. In short, under the compound interest method, you earn interest on the principal amount invested, and at the same time, you also earn interest on the interest already earned.
To understand the compound interest in a simple way, and to truly appreciate its magic, let’s take an example – you invest 10,000 rupees at a 5% interest rate. Let’s see how it looks over a period of 5 years under both simple interest and compound interest methods –
This is how compounding works, and over time it leads to extensive gains. While the gains of compounding might seem very small, and even insignificant, in the short run; they reap immense benefits for investors in the long run. It also depends on the amount of principal invested and the time period involved. The true magic of compounding can be felt only after a few years.
Compounding is what creates true wealth for investors in all kinds of investment vehicles, including stock markets, fixed deposits, and others.
Also Read: Shriram City Fixed Deposit Interest Rate
There are two kinds of compound interest available –
1. Periodic Compound Interest – Under periodic compounding, the interest rate is applied at pre-decided intervals, generally, of equal periods of time; for example – on a monthly, quarterly, or yearly basis.
2. Continuous Compound Interest – Under continuous compounding, the natural, log-based formula is used, and interest is applied at the smallest possible interval and added to the principal amount.
Fixed deposit investments, generally, yield interest on a periodic compound interest basis. Rarely does a financial institution offer continuous compound interest on investments.
Most financial institutions offering fixed deposits use compounding to calculate the interest amount on the principal. However, some banks and NBFCs do use simple interest methods as well. Hence, it is best to be aware of your options and conduct due diligence before investing your money in any fixed deposit. Ensure that your FD is being provided interest on a compounded basis.
The other thing that makes a difference is the compounding period. Different fixed deposits are offering different compounding periods; for example, some are applying interest at quarterly intervals while some are applying interest on an annual basis. Naturally, the shorter the compounding period, the greater the return you will get on your investment. Hence, before investing in a fixed deposit, check the compounding period also.
Hence, if you want to avail the maximum benefit out of investing in a fixed deposit, then ensure that you check all these points and then go ahead. It is always better to be cautious and do your due diligence in investing!
Shriram City Union Finance Fixed Deposit is one of the unique fixed deposit scheme available in market. It not only offers one of the highest interest rate in the market compared to any bank or NBFC’s but also under cumulative fixed deposit scheme the interests are cumulated on a monthly basis. This monthly compounding gives you the highest effective yield in long run. For example, if you’re investing Rs. 100000/ for the five years’ period at the end of the tenure you get maturity amount of Rs. 149,700/ which translate effective yield of 9.94% p.a.. This uniqueness makes Shriram City Fixed Deposits as most compelling investment option in the market.