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calenderJun 11, 2024

Compounding in Fixed Deposits: How does it work?

When it comes to saving and investing, finding a secure option with guaranteed returns is crucial. One such reliable and beneficial option is the compounding Fixed Deposit (FD). This type of investment not only offers safety but also leverages the power of compounding to maximie your returns.

What is a Compounding Fixed Deposit?

A Compounding Fixed Deposit is a financial instrument where the interest earned is added to the principal amount, and future interest is calculated on this new principal. This compounding effect can significantly increase your earnings over time. Unlike simple interest, where you earn interest only on the principal, compound interest in a Fixed Deposit allows your investment to grow at an accelerated pace.

How Compounding FD Works

To understand how a Compounding FD works, let's take a closer look with an example. Assume you invest ₹2,00,000 in a Fixed Deposit with an annual interest rate of 6%, compounded quarterly.

  • Initial principal: ₹2,00,000
  • Annual interest rate: 6%
  • Compounding frequency: Yearly
  • Tenure: 3 years

Here's a table illustrating the growth of your investment over 3 years:

Year Principal at Start Interest Earned Principal at End
1 ₹2,00,000 ₹12,000 ₹2,12,000
2 ₹2,12,000 ₹12,720 ₹2,24,720
3 ₹2,24,720 ₹13,483 ₹2,38,203

By the end of the fifth year, your initial investment of ₹2,00,000 grows to ₹2,38,203. This demonstrates the power of compound interest in Fixed Deposit, where the interest earned each is added to the principal, and the interest for the next period is calculated on this increased principal.

Benefits of compounding Fixed Deposits

A compounding Fixed Deposit (FD) is an excellent investment option that leverages the power of compound interest to enhance your earnings. Here are some key benefits of choosing a compounding FD:

1. Higher returns: The primary advantage of a compounding FD is the higher returns compared to simple interest FDs. The interest earned is reinvested, leading to exponential growth of your investment.
2. Security: FDs are one of the safest investment options, offering guaranteed returns. Your principal amount remains secure, and the returns are predictable.
3. Flexible tenure: You can choose the tenure of your FD based on your financial goals. Most banks offer FDs ranging from 7 days to 10 years.
4. Easy to manage: Managing a compounding FD is straightforward. You can easily track your investment and calculate the returns using a Fixed Deposit calculator.
5. Tax benefits: Investing in tax-saving FDs can offer you tax deductions under Section 80C of the Income Tax Act.

Maximising returns with a Fixed Deposit calculator

To make the most out of your compounding Fixed Deposit, it's essential to use a Fixed Deposit calculator. This tool helps you estimate the maturity amount based on the principal, interest rate, compounding frequency, and tenure.

Here’s how you can use it:

1. Enter the principal amount: Input the amount you plan to invest.
2. Select the interest rate: Use the interest rate offered by the bank.
3. Choose the compounding frequency: Select how often the interest is compounded (e.g., quarterly, half-yearly, annually).
4. Select the tenure: Enter the duration for which you want to keep the FD

Also Read: Six reasons to invest in Public Provident Fund now!

Let’s continue with the earlier scenario to see how quarterly compounding frequency can affect the maturity amount. Investing ₹200,000 at an annual interest rate of 6%, compounded quarterly for 3 years.

In the quarterly compounding scenario, the maturity amount is slightly higher due to the more frequent compounding, showcasing the benefits of selecting the right compounding frequency.

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.