Introduction:
Having a bank account is the need of today’s world. But why is it so?
It is because of the various advantages that a bank account provides. It includes the safekeeping of the money, giving you the freedom of carrying cash from one place to another, etc.
Along with all these different facilities, generally, you will also receive interest on the money that you keep in a bank account.
So, what is the method of interest calculation used by the banks?
Why knowing the Interest rate is important?
Before knowing about the method of interest calculation let us first know what is the interest rate and why it is important?
Basically, the interest rate given by the bank is the rate at which your money in the bank grows [generally per annum].
Suppose a bank gives a simple interest of 4% per annum and you had kept Rs.100 for 1 year in the bank then after a year, you will have Rs. 104 in your bank i.e., your money has grown 4% in a year.
But, in India RBI regulates the different commercial banks to give compound interest to their account holder instead of simple interest.
In compound interest, you will get interest on both principle as well as on the interest gained in a particular period. This period is called the compounding period.
At present, in India, the Reserve Bank of India has fixed the compounding period for the commercial banks as 3 months. The calculated interest is also to be credited in the bank account of the holder on a quarterly basis.
So, if you have deposited Rs. 100 in a bank account in India which gives you 4% interest per annum. Then by calculation, after three months your bank account will be credited with Re. 1 as interest.
Thereafter the interest calculation is done on Rs. 101 instead of Rs. 100 that you had deposited.
So, while choosing a bank account you should consider a bank account with a higher rate of interest. As higher the interest rate, higher will be the interest gained.
What is Interest calculation method?
Mathematically, there is a simple formula to calculate the compound interest on a fixed amount.
Compound Interest Calculator by Groww
Compound Interest Calculator by "thecalculatorsite"
But the case with the banks is not that simple. Why?
This is because the net deposited amount in a bank account is not fixed.
For a simple savings bank account, the investor can withdraw and deposit the money from the bank whenever he/she wishes.
This anytime withdrawal and deposit facility creates a lot of kiosk in the selection of principle amount for calculation of interest.
So, for the selection of the Principal amount, there was a certain set of rules that keeps banks in the favourable position. This rule is discussed under the heading “Old interest calculation method”.
Old interest calculation method
This old way of selection of Principle amount for interest calculation was in effect on or before 31st March 2010.
This rule had the following key points:
· Interest is payable only on the total deposits that have been made on or before 10thday of the month. The deposits that are made after the 10th day will be considered for the interest payment in the next month.
· The withdrawal that has been made on any day of the month will be considered in the selection of Principle amount.
Simply speaking, the interest will be calculated for a savings bank account either on the maximum amount in the bank account on or before 10th day of the month or the minimum amount between 11th day of the month to the last day of the month, whichever is lower.
So, the bank was playing a very safe game. When this rule was in effect, the bank was only considering the deposits that were made on or before the 10th day of the month. But bank was considering all the withdrawals that have been done in that month.
Let us consider a hypothetical scenario and calculate the interest on the deposits.
Down below you will find in detail 4 different scenarios of interest payment.
Case | Balance on 1st April 2008 | Deposits on 6th April 2008 | Deposits on 16th April 2008 | Withdrawal on 6th April 2008 | Withdrawal on 26th April 2008 | Amount considered for interest payment | Total interest paid for April 2008 |
1. | 5,00,000 | 1,00,000 | 1,00,000 | N/A | N/A | 6,00,000 | 1,740 |
2. | 5,00,000 | N/A | 1,00,000 | N/A | 2,00,000 | 4,00,000 | 1,160 |
3. | 5,00,000 | N/A | N/A | 1,00,000 | 1,00,000 | 3,00,000 | 870 |
4. | 5,00,000 | 1,00,000 | 1,00,000 | N/A | 1,50,000 | 5,50,000 | 1,595 |
All the above calculations are made based on Old Interest Calculation method. Interest rate is taken in the above calculation as 3.5% per annum. All the figures used in the above calculation are in INR.
The interest shown in the above calculation is to be credited on a quarterly basis, not on monthly basis.
New Interest calculation method
This rule came into effect from 1st of April 2010, when Reserve Bank of India passed a circular regarding the method of interest calculation and the amount on which the interest is to be calculated.
The circular had the following key points:
· The interest to be calculated from 1stof April 2010, will be done on the end-of-the-balances for the different savings deposit accounts with all the scheduled commercial banks.
· This method is to be applied for all the domestic savings deposit accounts.
· No discrimination is to be made across any of the branches.
· Interest is to be paid on a quarterly basis.
· The interest to be paid must have to be rounded off to the nearest whole number.
In simple words, the interest is to be paid on the end-of-the-balances.
This can be further simplified that the interest is to be paid on the Average Monthly Balance or AMB.
To Know more about Average Monthly Balance or AMB CLICK HERE!
Now, let us see what is the impact of this new method of interest calculation on the interest to be paid.
Case | Balance on 1st April 2020 | Deposits on 6th April 2020 | Deposits on 16th April 2020 | Withdrawal on 6th April 2020 | Withdrawal on 26th April 2020 | Average Monthly Balance or AMB | Total interest paid for April 2020 |
1. | 5,00,000 | 1,00,000 | 1,00,000 | N/A | N/A | 6,33,333.34 | 1,837 |
2. | 5,00,000 | N/A | 1,00,000 | N/A | 2,00,000 | 5,16,666,67 | 1,498 |
3. | 5,00,000 | N/A | N/A | 1,00,000 | 1,00,000 | 4,00,000 | 1,160 |
4. | 5,00,000 | 1,00,000 | 1,00,000 | N/A | 1,50,000 | 6,08,333.34 | 1,764 |
Confused about Average monthly Balance! Read here What is Average Monthly Balance and what is its impact on various features of a bank account.
All the above calculations are made based on New Interest Calculation method which is in effect from 1st April 2010.
Interest rate is taken in the above calculation as 3.5% per annum. All the figures used in the above calculation are in INR.
The interest shown in the above calculation is to be credited on a quarterly basis, not on monthly basis.
From the above two tables on the Old interest calculation method and New interest Calculation method, it is clear that New interest Calculation method is more in the favour of the account holder in the bank.
But it would be more perfect to say that New Interest Calculation Method is unbiased.
Do compare the interest gained by both new and old method for the same scenario! This will let you know the true benefit of the new method of interest calculation which is in effect from 1st of April 2010.
Key Factors affecting the interest gained on the deposits:
The following are some key factors affecting the interest gained on the deposits in a bank account:
· As of November 2020, for a particular day, you are liable to get the interest only on the end-of-the-day-balance.
So, for any amount, you deposit and withdraw on the same day is not included for interest calculation.
· It is not like that interest for a particular day is credited on the very next day. The interest payment cycle for the commercial banks in India, as decided by the Reserve Bank of India, is a quarter.
So, interest earned by your deposits is credited in your account is credited on a quarterly basis.
Other factors on which you should keep an eye to maximize the Interest Gained:
· The net interest rate: Generally, the interest rate for all the major banks is near about same. But it may vary among several other banks.
As of November 2020, State Bank of India pays interest of 2.75% per annum [may vary] but some other banks like Equitas Small Finance bank pay interest up to 7.5% per annum [may vary].
· The net deposit: It is obvious that the interest gained is directly affected by the total deposit in the bank account. More you deposit, more will be your interest gained.
Generally, banks give prior notice before changing their net interest rate. You should keep a follow on this to maximize your interest gained.
You should also keep in mind that the interest gained on a deposit is taxed if the net interest gained exceeds more than Rs. 10000 is a financial Year.
Different sources
Old interest rate calculation method Click here to Visit Source
New interest Rate Calculation Method Click here to Visit Source
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