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Beware! Banks May Be Trying To Fool You.

Open any newspaper today and you are likely to be bombarded with many ads from banks soliciting you to invest in their Fixed Deposits.

Each one is trying to out-do the other by offering very lucrative interest rates.

This competition is definitely good for the investors. However, in their anxiety to appear superior, some banks are resorting to ads that border on being unethical. This is unfortunate.

The levels of financial literacy in India are low. And these ads are trying to exploit this weakness of an average investor. The more unfortunate part of this whole story, however, is that these are not some obscure and unknown banks. Rather, they are among the biggest ones.

Let us look at one such example.

Given below is the advertisement issued by some banks regarding interest rates being offered on their Fixed Deposits.


So what is the problem?

The problem is that the Annualized Yields mentioned are WRONG.

Why are they wrong? They are wrong because it APPEARS as if your 'annual return' is much higher as your FD tenure increases — for example 11.59% for a 5-year deposit or 14.95% for a 10-year deposit. In reality this is not so.

Actually, the bank is calculating simple interest assuming as if your principal amount is constant throughout the 10-year period. As per simple interest formula:

Amount = Principal * (1 + Rate of Interest * No. of Years)

(Fake) Rate of interest = ((Amount/Principal)-1)/10 = ((24594-10000)-1)/10 = 14.95%

[Note: Maturity value for a 10-year deposit is given as Rs.24594]

However, this is not the case. Every year you are earning interest. This interest gets added to your principal. So every year your principal is increasing. Hence, applying the simple interest formula to a compounding investment is not correct. As per compound interest formula:

Amount = Principal * (1 + Rate of Interest)^No. of Years 

(Real) Rate of interest = (Amount/Principal)^(1/No. of Years)-1 = (24594/10000)^(1/10)-1 = 9.58%.

... If you keep your money for longer periods, naturally your total amount on maturity will be higher.
... If your maturity amount is more, naturally it will APPEAR as if you have earned "more" money. 
... This more money will APPEAR as earning higher interest, if you apply the simple interest formula.
That's why annualized return using simple interest is 11.59% for a 5-year deposit and 14.95% for a 10-year deposit.

In short, the investor is given the WRONG impression that s/he is earning higher returns. I repeat — this is wrong and misleading representation of the returns that you are actually getting.

Therefore BEWARE - appearances can be deceptive!

By the way, in reality you are getting interest @9.25% per annum (payable every quarter). And because of this quarterly compounding, the effective return or true annualized yield is 9.58%... whatever may be the period of FD.

Moreover, the interest rate is same for different periods. So logically how can the annualized yield be different?

I wonder why Reserve Bank of India is doing nothing about this?

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