When we invest in a bank fixed deposit or a corporate fixed deposit, the aspect that we focus most on is the interest rate.
What about the frequency of compounding?
For instance, what do you think of the following three options?
8% p.a. compounded annually
8% p.a. compounded semi-annually (or quarterly)
8% p.a. compounded quarterly
Are these three options the same?
The frequency of compounding affects your returns.
Even you may think that you are earning 8% p.a. in all three cases, that is not the case.
How? Let’s find out.
Suppose you invest Rs 1 lacs in three instruments giving these returns.
To find the actual return that you earn, you need to divide the interest rate by the number of periods in the year.
Therefore, when we talk about interest being compounded quarterly, there are four quarters in a year.
To, calculate the effective rate of return, you need to do the following calculation.
(1+interest rate/no. of periods)^(no. of periods)-1
(1+8%/4)^4= (1+2%)^4 = 1.0824 (The rate of return is 8.24% p.a.)
This means 8% p.a. compounded quarterly is equivalent to 8.24% p.a. compounded annually.
Similarly, 8% p.a. compounded semi-annually (or half-yearly) is equivalent to 8.16% p.a. compounded annually.
If you invested Rs 1 lac for 5 years in the three instruments, what will you end up with?
- 8% p.a. compounded annually
- 8% p.a. compounded semi-annually
- 8% p.a. compounded quarterly
I have not considered the effect of taxes and TDS.
Please understand you will see the effect of compounding only if the interest is not paid out (in case of cumulative fixed deposits). If the interest is paid out regularly, there is no compounding and the effect will go down (unless you reinvest the proceeds).
For instance, if you invested Rs 1 lacs in an instrument at 8% p.a. (where the interest is paid out annually) and in another instrument where interest is paid out on a half-yearly basis.
In the first case, you will get Rs 8,000 every year. In the second case, you will get Rs 4,000 every six months. If you reinvest the interest payouts, you will see the same impact as we discussed earlier.
However, if you don’t reinvest the interest payments (and spend the payouts), the effect will be very limited.
It is not that the bank will negotiate the compounding frequency with you. However, you should be able to calculate the actual rate of return that you are earning. If you know how calculations work, you will be able to make an informed choice.
For instance, now you know 8% p.a. compounded quarterly is better than 8.15% p.a. compounded annually.
Investopedia: Accelerating Returns with Continuous Compounding