How Your Bank Calculates Interest: A Guide To Savings & Fixed Deposits
Banks offer a variety of ways to earn interest on your deposits, but understanding how this interest is calculated is key to maximising your returns. Whether you are maintaining a Savings Account for regular transactions or opening a Fixed Deposit (FD) to secure your funds, knowing how interest is computed will give you a clearer perspective on how your money grows. While most calculations are handled by sophisticated banking systems, grasping these methods ensures you are fully aware of the returns you are receiving.
This article provides a fresh take on interest calculation for both Savings and Fixed Deposit Accounts, highlighting how they work, especially when premature withdrawal is involved.
Savings Account Interest Calculation
Interest on a Savings Account is one of the simplest ways to earn money on the balance maintained. The calculation method, however, has undergone a transformation over the years.
Pre-2010 Method
Prior to 2010, interest on a Savings Account was calculated on the lowest balance available between the 10th and the last day of the month. This meant that even if you maintained a higher balance for most of the month, the interest earned would only be based on the lowest balance in that specific period. For instance, if your balance dipped to Rs.1000 on the 10th of the month, interest would be calculated on that Rs.1000, even if your balance had been much higher before and after.
Post-2010: The Daily Balance Method
In 2010, the Reserve Bank of India introduced a more transparent and beneficial approach, making it mandatory for banks to calculate interest on the daily balance. Here’s how it works:
Savings Account Interest Formula
Interest = Daily Balance × Interest Rate × Number of Days / 365 × 100
Let’s break this down with an example
Imagine Rajeev has a Savings Account that earns an interest rate of 4% per annum. His account activity in May looks like this:
- On 1st May, his balance is Rs.200,000.
- On 6th May, he withdraws Rs.60,000, reducing the balance to Rs.140,000.
- On 10th May, he deposits Rs.40,000, increasing the balance to Rs.180,000.
- By 20th May, his balance rises to Rs.195,000 after further transactions.
- From 1st to 5th May (5 days), interest on Rs.200,000 = Rs.109.59.
- From 6th to 9th May (4 days), interest on Rs.140,000 = Rs.61.37.
- From 10th to 19th May (10 days), interest on Rs.180,000 = Rs.197.26.
- From 20th to 31st May (12 days), interest on Rs.195,000 = Rs.256.44.
How Is Interest Credited?
Although banks calculate interest on a daily basis, they credit it to your account either quarterly or semi-annually, depending on their policies. Therefore, while the money earns interest daily, it may take some months for it to reflect in your account balance.
Fixed Deposit Interest Calculation
Fixed Deposits (FDs) offer a higher interest rate compared to Savings Accounts, but they come with a lock-in period. If you hold your FD until maturity, the interest is straightforward to calculate. However, if you withdraw funds prematurely, the bank may reduce the interest rate and impose penalties.
Scenario 1: Holding the FD until Maturity
For instance, Rajeev opens an FD with Rs.200,000 for a period of one year, earning 8% interest per annum. The calculation for the interest earned would be:
FD Interest Formula
Interest = Principal × Interest Rate × Tenure / 365 × 100
In Rajeev’s case
- Principal = Rs.200,000
- Interest Rate = 8%
- Tenure = 1 year (365 days)
Interest = 200,000 × 8 × 365 / 365 × 100 = Rs.16,000.
On maturity, Rajeev will receive Rs.216,000, excluding taxes.
Scenario 2: Premature Withdrawal of FD
If Rajeev decides to withdraw his FD after six months, the calculation changes. Although he initially booked the FD at 8% for a year, the bank will only offer the interest rate applicable for a six-month deposit, which in this example is 6%. Moreover, a penalty of 0.5% is levied for premature withdrawal, bringing the effective interest rate to 5.5%.
The interest calculation for premature withdrawal would be
Interest = 200,000 × 5.5 / 100 = Rs.11,000.
Thus, Rajeev would receive Rs.211,000 after six months, lower than the full maturity amount.
The Importance of Understanding Interest Calculations
Whether you are earning interest on a Savings Account or investing in a Fixed Deposit, it’s vital to understand how banks calculate interest. Being aware of how your money grows ensures that you have full control over your finances and can make informed decisions. For example, when choosing an FD, knowing the penalties for early withdrawals can help you decide whether to lock your funds or opt for more flexible savings options.
Many online calculators allow you to easily compute interest on your Savings or Fixed Deposit Accounts, offering clarity and helping you maximise your returns.