Source: The Economic Times.
The battle for deposits is getting tougher by the day with each institution offering high rates of return to attract investors. Banks are now pulling out all stops to garner more deposits. While the rate of return is an important factor to consider in the case of deposits, another factor impacts the extent of return earned — this is the time period when the interest is compounded. Various ways are used in the compounding process, which impact the final returns generated for an investor. Let’s take a look at the compounding effect and how it affects investors.
The shorter the time period for compounding, the better it is for the investor because the effective rate is higher. There are two ways of calculating interest. The first is the simple interest method of calculation, where the interest is calculated for a specific period based upon the original amount of investment at the given rate of interest. For example, if the invested amount is Rs 10,000 and the simple interest rate is 8% p.a. for one year, then the interest will be Rs 800 for the entire year. The second way of calculating interest is the compounded method, where at the specified time interval, the base for the calculation of interest changes to include the interest already earned for that time period. So, if an investment of Rs 10,000 earns 8% compounded quarterly, then at the end of the first quarter, the base for calculation of interest becomes Rs 10,200 and hence, the interest earned will also be higher in future. So, the investor will earn a larger sum of money at the end of the period. The time period after which an item is compounded helps an individual to know the impact of compounding. This can be done either monthly, quarterly, half-yearly or annually. The time period is significant in determining the final rate of return that will accrue to a person. Suppose an investment is made for a period of one year. Let’s compare the impact that different levels of compounding will have on the return figure at the end of the year. The return for the period is taken at 8% as this is the current rate of return prevalent in the economy.
If there is annual compounding and the investment is only for a year, then for the specific time period, the rate of return that is earned will remain at 8%. Two points need to be considered here — the first is the interest rate that has to be used for the purpose of calculation and the second is the time period. To arrive at a common ground, it is better to check the annual return that will be generated under various compounding routes. In case of half-yearly compounding, the base capital will go up by 4% at the end of six months due to the earnings generated and hence, on an overall basis, the return will be 8.16% at the end of the year. The additional 0.16% is on account of a rise in the base after half a year. In case of quarterly compounding, the effective rate for the year goes up to 8.24%, while in the case of monthly compounding, the rate rises further to 8.3%. This shows how the effective return for the investor can rise by compounding the money at shorter time intervals. Hence, individuals can make the most of compounding.
The battle for deposits is getting tougher by the day with each institution offering high rates of return to attract investors. Banks are now pulling out all stops to garner more deposits. While the rate of return is an important factor to consider in the case of deposits, another factor impacts the extent of return earned — this is the time period when the interest is compounded. Various ways are used in the compounding process, which impact the final returns generated for an investor. Let’s take a look at the compounding effect and how it affects investors.
The shorter the time period for compounding, the better it is for the investor because the effective rate is higher. There are two ways of calculating interest. The first is the simple interest method of calculation, where the interest is calculated for a specific period based upon the original amount of investment at the given rate of interest. For example, if the invested amount is Rs 10,000 and the simple interest rate is 8% p.a. for one year, then the interest will be Rs 800 for the entire year. The second way of calculating interest is the compounded method, where at the specified time interval, the base for the calculation of interest changes to include the interest already earned for that time period. So, if an investment of Rs 10,000 earns 8% compounded quarterly, then at the end of the first quarter, the base for calculation of interest becomes Rs 10,200 and hence, the interest earned will also be higher in future. So, the investor will earn a larger sum of money at the end of the period. The time period after which an item is compounded helps an individual to know the impact of compounding. This can be done either monthly, quarterly, half-yearly or annually. The time period is significant in determining the final rate of return that will accrue to a person. Suppose an investment is made for a period of one year. Let’s compare the impact that different levels of compounding will have on the return figure at the end of the year. The return for the period is taken at 8% as this is the current rate of return prevalent in the economy.
If there is annual compounding and the investment is only for a year, then for the specific time period, the rate of return that is earned will remain at 8%. Two points need to be considered here — the first is the interest rate that has to be used for the purpose of calculation and the second is the time period. To arrive at a common ground, it is better to check the annual return that will be generated under various compounding routes. In case of half-yearly compounding, the base capital will go up by 4% at the end of six months due to the earnings generated and hence, on an overall basis, the return will be 8.16% at the end of the year. The additional 0.16% is on account of a rise in the base after half a year. In case of quarterly compounding, the effective rate for the year goes up to 8.24%, while in the case of monthly compounding, the rate rises further to 8.3%. This shows how the effective return for the investor can rise by compounding the money at shorter time intervals. Hence, individuals can make the most of compounding.
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