Don’t confuse yields with interest rates

by Manshu on June 15, 2011

in Fixed Deposits

Last week, a reader pointed me to fixed deposits from Avon Corporation, and my eyes naturally gravitated towards the highest number in the table viz. 14.19% yield  p.a. for a 3 year fixed deposit.

On the face of it this looks quite high, but that’s because your reference is usually a fixed deposit interest rate, which is different from this yield.

It is important to understand this difference because there are a lot of private companies that offer fixed deposits, and they usually do advertise the effective yield. I don’t write about company fixed deposits a lot, but when I checked a 2009 article about Tata Motors fixed deposit – I saw that they used the same annual yield as well.

Usually companies give you two options:

  • Periodic interest payment
  • Cumulative option

The periodic interest option is usually straightforward, as they advertise the rate of interest you will get for your deposit.

However, the cumulative plan becomes confusing because they advertise an interest rate and an annual effective yield.

Let’s use the numbers given in the Avon example. They say that the minimum investment is Rs. 5,000, tenure is 3 years, interest is compounded quarterly, and the yield per annum is 14.19%.

So, what does that mean – are you getting 14.19% interest per year which is then re-invested for you?

No, absolutely not.

Their brochure tells you that  you’re getting 12.00% interest rate for the 3 year maturity period, so where does the 14.19% number come from?

Since, this is a cumulative option you won’t get any interest payments, and get a lump – sum payment at the end of three years. Use the Compound Interest calculator to calculate how much you will get at the end of 3 years.

This gives us Rs. 7,128.80 at the end of 3 years.

So, for Rs. 5,000, you get interest of Rs. 2128.80 for 3 years. Divide that by 3 to get the annual interest – Rs. 709.43.

And (709.43 /5000) x 100 = 14.19%.

This is your annual effective yield.

Conclusion

You can’t compare this 14.19% with the interest rate that banks normally show because that’s like comparing apples and oranges.

This number is high only because it has been compounded for 3 years, then divided equally by three years, and you use the initial principal of Rs. 5,000 as base.

If you were to get a fixed deposit with a bank at 12% for a year, and re-invest that money again for two more years you will get the same effect.

I think this post is important for people who are interested in depositing money with companies, so please keep the distinction between yields and interest rates always in your mind, and don’t confuse one with the other.

{ 18 comments… read them below or add one }

Subodh June 15, 2011 at 10:05 am

very informative post; well explained with a case! I am sure all readers will now understand the power of compounding.

Reply

Manshu June 15, 2011 at 8:06 pm

Thanks Subodh – compounding is wonderful isn’t it? If you continue to increase the duration of this kind of FD without increasing the rate of interest – the yield will continue to increase every year 🙂

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piyush modi June 15, 2011 at 10:36 am

Though this comment is not particularly relevant to this post, but I wanted to leave it and want you to write about it cause I am sure it will help many many of your readers.

My dad has a home loan with ICICI Bank which was once taken at a floating rate of 7.5%, and which now stands at 14.5% rate. I recently called up ICICI Phone banking to ask the procedures for a balance transfer to a different bank & I was told that they are running a scheme where existing customers could move to a lower rate of interest. I was skeptical at first, but then went through with the documentation required and apparently its an amazing scheme. Obviously ICICI wont advertise it or inform you, but it is available.

My dad’s rate has been reset from 14.5 to 10.5% a huge 4% difference. His tenure, which was originally 180 months, and had now gone up to 315 months despite making the EMI repayments for the last 4-5 years (60 months approx) stood slashed at one go to 160 something. Alternatively, one can choose to reduce one’s EMI instead of choosing to reduce the tenure.

For those wondering how such a drastic reduction in tenure is possible, it can happen. In this case, the total EMI was approximately equal to the interest charged in a year and only a very small amount (4-5%) of the EMI was being used to repay capital. With the fall in the rate charged by 4%, this shifted up considerably to 25-27% of the EMI, and this means that a lot more of the EMi is being used to repay capital instead of just service debt and this leads to drastic reduction in tenure.

What were the documentation/formalities required –

1. Cheque for a charge of 0.5% of balance outstanding on the loan+service tax on the same.
This is extremely cheap as I will recoup this charge within 2 months
2. Non-judicial stamp paper of Rs 30 signed by borrower & co borrowers
3. Some sort of an agreement which you will get from the bank itself and has to be signed by borrower & co borrowers
4. All outstanding EMI payments have to be cleared (obviously)

Now I am not sure whether the scheme is available for all home loan borrowers or a particular category, as also the amount of reduction in rates will be the same for all borrowers or not. But give a call to ICICI bank and just ask. It will save you a tonne of money.

Reply

Manshu June 15, 2011 at 8:05 pm

Thanks for that comment Piyush – I wasn’t aware of anything like it, and I’m sure people can make use of this info. I’ll convert it into a post and publish it soon. Thanks.

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Subodh June 16, 2011 at 11:30 am

“floating” rate should come down automatically as per the prevailing market rates. It is sad that private banks charge fees for that, and unfortunately clients still see this as “Great service”. had you taken loan with public sector bank such as SBI, the rate would have automatiaclly come down (without any charge). Thats what floating rate is!

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piyush modi June 16, 2011 at 12:48 pm

Subodh you are clearly missing the point.

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Subodh June 16, 2011 at 7:54 pm

May be I missed the point, and so did MGM and Pallavi (commented on today’s post). But one thing is for sure. Having worked in financial industry for 6 years (including 2 years in ICICI), I have understood the difference between fixed rate and floating rate. I personally took floating rate loan anticipating that it will come down as smoothly as it goes up, depending on market rate. no offense to anyone, I am also a blogger – willing to share my views 🙂

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Manshu June 16, 2011 at 8:09 pm

Just curious, which public sector bank did you take the loan out with Subodh, and what was the magnitude of change?

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Subodh June 16, 2011 at 8:25 pm

I took loan from SBI, not because my father worked for almost 30 years in SBI, but because I liked their transparency, daily reducing balance feature and min foreclosure charges. My loan was the teaser one, so for 3 years its fixed at 8%, 9.5% and 9.5%. after that it will be floating. Officers have assured that it will keep increasing / decreasing as per the market rate.

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piyush modi June 16, 2011 at 8:31 pm

@ subodh –

ok maybe I phrased my response incorrectly. obviously no one more appreciates the fact that customers were taken for a ride by private sector banks than me, whose rate of interest actually doubled, which was when I took the loan right at the bottom of the rate cycle.

but irrespective of the fact that floating rates should be market linked and the rates should have been much lower if banks had been fair.. the current scheme is pretty good and all icici bank home loan customers should avail it. infact after this experience I decided I will not take a loan from private sector banks, but the fact is that the PSU banks are so slow is their processing and need thousand different things and is a real pain in the whole process..

I would assume that the reason this scheme was launched was because icici was probably losing customers by the drove.. if i was paying 14% when i started at 7.5, other might well be paying 16-17%.. irrespective of that, its to be grabbed by both hands and save a lot of money. my dad was shocked to hear that outstanding tenure was like halfed by this move

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Subodh June 16, 2011 at 8:44 pm

Oh yeah, I agree with you.
It was good that your Dad contacted them. Other clients of ICICI and other private banks should also check with their bank. Especially if they know that they are paying higher interest rate than what bank is offering to new clients.
Thanks for taking your time to explain it. Much appreciated.

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MD. YOUSUF June 15, 2011 at 12:01 pm

Thanks for showing how the annual yield arrived. Now one can easily compare between options.

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Manshu June 15, 2011 at 8:03 pm

Yeah, I’m trying to build a calculator to make that process even simpler; knowing that the difference exists is a good first step for sure!

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Kapil Dev Tejwani June 15, 2011 at 12:17 pm

Thank you Manshu for this wonderful post.Am sure this will help many people like me.
For once I too got confused then your simple caculations cleared it all…Thanks much…

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Manshu June 15, 2011 at 8:02 pm

This kind of thing is easy to lose sight of if you’re not looking for it carefully. Normally, we just tend to look at the numbers, and don’t bother reading too much into the details of what those numbers are.

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Kapil Dev Tejwani June 16, 2011 at 12:03 pm

Yeah tru..A Layman would definitely be carried forward by marketers claims of high yields….

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Himanshu Bansal June 19, 2011 at 4:20 am

Thank you Manshu. This is really informative. The distinction is just like “super built up area” and “carpet area”. You get yield but you need to consider the difference between yield and interest rate.

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Manshu June 19, 2011 at 7:35 am

Thanks Himanshu – that’s a very good analogy – I hadn’t thought of it that way 🙂

Reply

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