Suppose you invest a lump sum of Rs 5,00,000 at 8 percent a year, compounded quarterly, for 10 years. Quarterly compounding means the rate is divided into four periods a year, so each quarter earns 8 divided by 4, which is 2 percent, and there are 4 times 10, or 40, compounding periods in all. The maturity value is the principal multiplied by 1.02 raised to the power of 40. That works out to about Rs 11,04,020. The total interest earned is the maturity value minus the original Rs 5,00,000, which is about Rs 6,04,020, slightly more than the amount you put in. Because interest is added four times a year rather than once, the effective annual yield is 8.24 percent, a little above the stated 8 percent nominal rate.
Step
Value
Principal
Rs 5,00,000
Nominal rate
8 percent per year
Compounding
Quarterly, 40 periods
Rate per period
2 percent
Maturity value
Rs 11,04,020
Total interest
Rs 6,04,020
Effective annual yield
8.24 percent
How it is calculated
Compound interest pays interest on both the principal and the interest already credited, so the balance grows faster than simple interest. The maturity value equals principal times (1 plus the rate per period) raised to the number of periods, where the rate per period is the annual rate divided by the compounding frequency and the number of periods is the frequency times the years. More frequent compounding gives a higher maturity for the same nominal rate, because interest starts earning its own interest sooner. The effective annual yield captures this by showing the equivalent once-a-year rate. In India, bank fixed deposits typically compound quarterly, while savings accounts pay interest on daily balances credited quarterly. The longer the horizon, the more dramatic the gap between principal and total interest becomes.
Frequently asked questions
Monthly vs annual compounding?
More frequent compounding gives a slightly higher maturity for the same nominal rate, because interest starts earning interest sooner. FDs usually compound quarterly; savings accounts compound on daily balances paid quarterly.
Is compound interest taxable in India?
Yes. Interest income is taxable under the head "Income from Other Sources" under the Income Tax Act. Banks deduct TDS at 10 percent once interest in a financial year exceeds Rs 40,000 (Rs 50,000 for senior citizens). You must include total interest earned when filing your ITR regardless of whether TDS was deducted.
How does the effective annual yield differ from the nominal rate?
The nominal rate is what the bank advertises. The effective annual yield (EAY) is the equivalent once-a-year rate after accounting for compounding within the year. For an 8 percent nominal rate compounded quarterly the EAY works out to about 8.24 percent. The gap widens with more frequent compounding.
Which Indian bank deposits use compound interest?
Fixed deposits and recurring deposits compound quarterly in most Indian banks, following Reserve Bank of India guidelines. Savings account interest is calculated on the daily closing balance and credited quarterly or half-yearly, which has a similar effect. The Public Provident Fund (PPF) compounds annually at the government-notified rate.