Let us face it, most investors are confused with the two percentages associated with a fixed deposit: annual interest and annual yield. Most people make the common mistake of assuming that the yield (often higher than the interest rate) is the interest rate!
So let us try to understand what each term represents.
If I invest Rs. 100 in a FD that offer 10% per year, my investment will grow to
- Rs. 110 at the end of 1 year
- Rs. 121 at the end of 2 years
- Rs. 133.1 at the end of 3 years.
If I want to represent this growth by a constant percentage, then I use the annual interest rate.
- 100 X (1+10%) = 110 (year 1)
- 100 X (1+10%) X (1+10%) = 121 (year 2)
- 100 X (1+10%) X (1+10%) X (1+10%) = 133.1 (year 3)
Therefore, the constant percentage is the annual interest rate of the FD, 10%
Suppose I want to know the relative difference in my investment at the end of each year,
- (110-100)/100 = 10% (year 1)
- (121-100)/100 = 21% (year 2)
- (133.1-100)/100 = 33.1% (year 3)
Although I understand the notion of the relative difference, I hope you agree with me that it does not help much. Obviously, the relative difference of a one-year FD will be more than that of a two year FD. Beyond that, relative difference does not give us an insight in the manner of growth.
Annual yield is defined as the relative difference in investment value per year of investment.
For each year of investment the annual yield is,
- 10%/(1) = 10% (year 1)
- 21%/(2) = 10.5% (year 2)
- 33.1%/(3) = 11.033% (year 3)
Key difference between the annual yield (rate) and annual interest rate:
Annual Interest rate is a constant for a fixed deposit. Annual yield rate increases with the increase in duration for the same interest rate.
For simplicity, I have considered annual compounding. Other types of compounding are available for analysis in the excel tool.
Now, let us say I work in a bank, and my job is to sell FDs, in particular the FD, we have considered above.
Which statement would catch a client’s attention?
A 3-year FD with 10% annual interest
‘a 3-year FD with an annualized yield of 11.033%’?
Obviously many people assume that their money will grow at the rate of 11.033%.
This is wrong. Their money will grow at 10% and will produce an annual(ised!) yield of 11.033%.
- Given the yield rate, the interest rate can be calculated.
- Given the interest rate, the yield rate for any duration can be calculated (why bother!)
- Use this excel tool to understand the relationship between yield rate and interest rate for a fixed deposit.
- This calculator was requested by Mr. Srinivas, a banker.
Download the Fixed Deposit Yield vs. Rate Analyzer
with total and advance tax liability each financial year, now updated with pre-tax and post-tax annual yields for each month of investment.
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