Interest rates are not that simple

“Since when have you bankers been paying higher interest than promised?” said Rohan to his neighbour, Narendra, a budding banking executive.

“Impossible!” said Narendra. “But tell me more.”

Rohan told him he had had invested his Diwali bonus of Rs 50,000 in a one-year fixed deposit with interest rate of 9.75 per cent and gone for the cumulative option, and he received Rs 55,056 now. At a simple interest of 9.75 per cent he should have received Rs 4,875. He got Rs 181 more.

Power of compounding

Narendra smiled knowingly. “You have calculated the simple interest rate on your deposit, Rohan. Since you held the deposit under the cumulative option, your bank has paid you the interest rate on quarterly rests. That simply means that the interest in the first quarter will be added to the principal amount. For the next quarter, interest is worked out on this balance. For instance, the first quarter interest on your Rs 50,000 is Rs 1,219. Now for the next quarter interest will be considered on Rs 51,219. The power of compounding makes you feel you received more than you ought to. There could be monthly, half-yearly or annual compounding too. You should know these facts before you invest.”

“Hey, that's not bad,” said Rohan, a little disappointed that the bank only paid him his due. “But I have deposits with some finance companies where interest is paid out quarterly or half-yearly. How are those worked out?”

Simple pay outs

“Don't get too greedy Rohan,” quipped Narendra. “Only if you allow the money to grow, will you be given the compounding benefit. Not when your bank or finance company pays you interest periodically. So the monthly or half-yearly payout rates offered will be slightly lower than the cumulative rate. Payout options offer you simple interest rates, while cumulative options calculate interest on interest.”

“You're right, I noticed that,” said Rohan. “But even the cumulative option had only an annual compounding of interest, not quarterly. So now I know different institutions follow different practices.”

Don't yield to ‘yield claims'

He continued, “But tell me, I am reading about bonds that fetch me 16 or even 17 per cent yield. Is yield the same as interest?

Narendra settled in his chair and explained, “These bond issuers and even companies that issue deposits have started using the term ‘yield' liberally. Good that you have raised it.”

“While yield is used in different contexts, in your fixed investments like bonds and deposits, yield is the total benefit you derive from investing in that scheme at a certain cost. For example, a deposit rate of 10 per cent a year for three years is a simple interest rate. Yield will include the benefit of compounding as well as any tax benefit you derive from the investment but after deduction of any tax payments on the interest.

Take the current ‘flavour of the month' infrastructure bonds. They allow you a tax deduction of Rs 20,000 in the year of investment.

Let us suppose it carries an 8.5 per cent interest rate for five years and you decide to go for the cumulative option. That means, if you are, say, in the 30 per cent tax bracket, you will get a tax deduction of Rs 6, 180 (30 per cent plus surcharge on Rs 20,000).

By saving the above amount, your effective outflow will therefore be Rs 13,820 in the year of investment (20,000 less 6,180).

And the usual compounding of Rs 20,000 at 8.5 per cent a year gives you Rs 30,073 after five years.

In effect you get Rs 30,073 for an investment of Rs 13,820. A bond issuer may therefore claim a 16.8 per cent yield!

Now that's not true. In all this, the interest that you receive, which is Rs 10,073 (Rs 30,073-20,000) is taxable. While the initial tax deduction at 30 per cent was considered, this taxability on your interest income is not counted by many. Hence, after tax of 30 per cent on your interest, the yield actually goes down to 14 per cent.”

“Even then, remember Rohan, it is not entirely right to showcase this yield because it varies based on your tax slab. If you are in the 20 per cent tax slab, your yield is lower because you get less tax benefits (20 per cent on Rs 20,000) than somebody in the 30 per cent bracket.”

With an approving nod Rohan said, “Interest rates are not that simple, after all.”

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