Personal Finance

How yield on deposits is calculated

Anand Kalyanaraman BL Research Bureau BL Research Bureau | Updated on December 19, 2020

It’s not so simple

Angry bird Bulbul gets some ‘interesting’ gyaan from agony uncle Babaji who revels in rhyme and reason

Bulbul: Businessmen always get what they want. Cheaper loans they asked for – and now they have it, with interest rates at multi-year lows. But in the bargain, savers and depositors like me are getting squeezed – most banks and companies now offer just about 5-7 per cent on fixed deposits. Not fair!

Babaji: Fret not so much, Bul. What goes up comes down and what goes down comes up. So will interest rates. It’s all temporary.

Bulbul: Whatever, Baba. But for now, I am on a hunt – for the best yields to shore up my already modest interest income.

Babaji: Hunt if you must, but don’t fall for illusions. ‘Cos what you see may not be what you get – especially when it comes to yield in this fickle financial field.

Bulbul: Another rhyming riddle and your fate is sealed! See this baton that I wield?

Babaji: Calm down, Bul. Let me make the complex simple, and see your smiling dimple. You see, when it comes to interest and yields, the simple can compound your problems. It gives you an illusion of more, and you could end up feeling sore.

Bulbul: Now, do you really want a gash and a gore?

Babaji: Nope, here’s the crux to the fore. When it comes to advertised yields, what you see is often an exaggerated number meant to entice you, dear depositor. That’s because many companies that accept deposits do not follow the correct definition of yield.

Bulbul: Pray, explain what you say.

Babaji: Yield, as per finance terminology, should ideally be calculated using the formula for compound interest, that is, Amount = Principal*(1 + Rate)^Period. But several deposit-takers calculate yield applying the simple interest equation, that is, Simple interest = (Principal*Period*Rate)/100. Re-arranging the formulae, the Rate in both the equations gives you the annual yield. Turns out, the simple interest formula churns out a much higher yield than the compound interest formula.

Bulbul: Oh my! Tell me why.

Babaji: Sure, let me try. In a cumulative deposit, the interest earned is reinvested and, in turn, earns interest in the subsequent period. These periodic additions to the capital need to be considered while calculating yield. The compound interest formula does that, the simple interest one does not.

Bulbul: Yelp! An example will help.

Babaji: Say, a company offers annual interest rate of 6.7 per cent on its cumulative deposits for a tenure of 5 years; the interest is compounded annually and Rs 5,000 will grow to Rs 6,915 in 5 years. The company advertises that the yield is 7.66 per cent, using the simple interest formula - while actually, the yield is only 6.7 per cent using the compound interest formula. If you get enamoured by the higher advertised yield, you could end up making a wrong choice. Greed often comes with misery, you know.

Bulbul: Enlightened, thanks. But how do I calculate the correct yield without getting into knots with complex formulae?

Babaji: Simple. Invoke the ‘Rate’ function in Microsoft Excel. It can do the job in a jiffy. Before you take the bait, wait and calculate.

Bulbul: That’s Simply Put.

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Published on December 19, 2020
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