Fixed deposit (FD) is a financial instrument where a sum of money given to a bank, financial institution or company whereby the receiving entity pays interest at a specified percentage for the time duration of the deposit. The rate of interest paid for fixed deposit vary according to amount, period and from bank to bank. At the end of the time period of the deposit the amount that is originally given is returned to the investor.
Features of Fixed Deposit Account
- The main purpose of fixed deposit account is to enable the individuals to earn a higher rate of interest on their surplus funds (extra money).
- The amount can be deposited only once. For further such deposits, separate accounts need to be opened.
- The depositor is given a fixed deposit receipt, which depositor has to produce at the time of maturity. The deposit can be renewed for a further period.
- As per the Traditional scheme, the interest on the FD account is credited to the Savings account specified by the depositor on a monthly basis or on a quarterly basis. For the Reinvestment scheme, the interest is compounded to the principal amount on a quarterly basis.
- Tax is deducted at source, from the interest on Fixed Deposits, as applicable, as per the Income Tax Act, 1961.
Duration of Fixed Deposit
Fixed deposit can be opened for a minimum period of 7 days to maximum of 10 years.
Eligibility for Fixed Deposit
All Resident individuals (Including Minors) and HUF are eligible to open a fixed deposit account
Compound Interest and Impact of Compounding frequency
Compound interest arises when interest is added to the principal so that from that moment on, the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding. The following formula gives you the total amount one will get if compounding is done:- Where, A = Final Amount that will be received P = Principal Amount (i. e. initial investment) r = Annual nominal interest rate (as a decimal i. e. if interest is paid at 5. 5% pa, then it will be 0. 055) (it should not be in percentage) n = number of times the interest is compounded per year (i. e. for monthly compounding n will be 12, for half year compounding it will be 2 and for quarter it will be 4 t = number of years
- Annual Compounding: In this case there is no compounding effect because the term is only one year, the same as the compounding frequency. Thus, all we have is simple interest (i. e. , the effective rate is equal to the nominal rate)
- Monthly Compounding: In this case there are 12 compounding periods. Interest earned each month is added to the balance and is itself available to earn interest in each succeeding month. Thus, the future value is greater than the amount calculated using annual compounding.
- Weekly Compounding: As should be expected,increasing the frequency of the compounding period increases the impact of the interest rate. That it does so should be intuitive: more interest is available sooner to earn more interest. Whereas before we had to wait until the end of the month before the interest was 'added back to the pot', now it is being credited each week.
- Daily Compounding: Now instead of earning interest weekly, we earn it daily. As expected the, the impact of the interest rate is magnified. However, this time the impact is not as dramatic as might be expected.
- Continuous Compounding: Interest that is, hypothetically, computed and added to the balance of an account every instant. This is not actually possible, but continuous compounding is well-defined nevertheless as the upper bound of "regular" compound interest. The result is the maximum effect that compounding frequency can exert on a given interest rate and term.