How to Calculate Fixed Deposit Interest?

What are the Two Ways to Calculate Interest on Deposits?

There are two major ways in which interest is calculated on term deposits. One is simple interest and the other is compound interest. Each method of fd interest calculation uses a different formula to calculate interest earned from the FD. Currently, interest on fixed deposits is calculated using the compound interest calculation formula. However, a clear understanding of simple interest calculation and formula is necessary to get a clear understanding of why FD interest is calculated this way.  

What is Simple Interest Calculation Formula?

Below is the simple interest calculation formula:

Simple Interest = Principal X Interest Rate X Time

Here, Principal is the original investment amount and time refers to the duration of the investment in years or months. Interest rate is usually represented as a percentage value either as an annual or monthly rate. So, in this fd interest calculation you will earn more interest if you stay invested longer, receive a higher interest rate on your deposit or invest a larger amount.

So, if you invest Rs. 5,000 for 3 years at 5% per annum interest rate, the simple interest earned will be as below:

Total Interest Earned = 5000 x 3 x 0.05 = Rs. 750. 

While, the above interest calculation formula is easy to understand and calculate, simple interest has a key drawback. There is no compounding i.e. your interest earnings do not play any part in growing your wealth further. In case you are wondering how to calculate FD interest accounting for compounding, this is taken into account by the compound interest formula. 

How is FD Interest Calculated Using Compound Interest Formula? 

Compound interest calculation formula takes into account compounding i.e. interest earned in the previous cycle earns interest in the subsequent cycle. So, in the case of annual compounding, interest earned on your deposit at the end of the 1^st year will become part of the principal used to calculate FD interest in the second year. This is how the power of compounding helps investors grow their wealth the longer they stay invested.

The compound interest calculation formula for FD looks like this:

Compound Interest = [P {1+ R /(100 X n)} ^(nt)] - P  

In the above formula, P= Principal, R= Annual interest rate, t= time period of investment, n= Number of times compounding occurs in a year. So, for annual compounding i.e. when interest is added to the principal amount once in year, the formula can be simplified as below:

Compound Interest (annual compounding) = P {1+(r/100)}^t - P

If you look at the above formula closely, you will realize that key difference between the simple interest and compound interest calculation of FD interest is that the interest in the previous period becomes the principal for the subsequent period, so, essentially you earn interest on interest just by staying invested leading to compounding of your investment.

Let’s see how this leads to capital appreciation using the previous example of initial investment of Rs. 5000, for a 3 year period and rate of 5% per annum compounded annually. With this data, the compound interest FD calculation will look like this:

Compound Interest = [5000 {1+(5/100)} ³] – 5000 = Rs. 788    

As you can see, how you calculate FD interest does impact how much interest is earned and compound interest earned was around Rs. 38 more even for the relatively short investment tenure of 3 years. If the tenure is longer, this difference in FD interest earned will be greater as the number of times compounding occurs will increase. You can easily check these differences using an online compound interest calculator.