by Manshu on April 3, 2012
Pradeep Sharma left a comment the other day about how he had set up a recurring deposit with ICICI Bank and how the final amount he was calculating was different from the amount that the ICICI Bank representative told him.
That difference was due to the fact that while he was compounding interest monthly, banks usually compound interest quarterly and that’s why he was getting a different answer.
Paresh responded to that comment telling him what caused the difference, and when I looked at the response, I thought I’d add to it by providing a link to how interest on recurring deposits (RDs) are calculated.
I was surprised to see that while there were quite a few recurring deposit calculators. there were hardly any explanations and the few that existed were really very short explanations on how interest on RD was calculated.
So, I decided to give it a try myself, and it took me an embarrassingly long time and several mistakes to do that even though the concept is very simple.
Understand Compound Interest To Understand Recurring Deposit Interest
When you create a RD for Rs. 10,000 for 2 years, what you’re doing is depositing Rs. 10,000 with the bank every month for 24 months, and the bank pays you interest on Rs. 10,000 for 2 years compounding it quarterly, then for the next Rs. 10,000 it pays you interest for 23 months, and so on and so forth.
Banks usually compound interest quarterly, so the first thing is to look at the formula for compound interest .
That formula is as follows:
A formula for calculating annual compound interest is
- A = final amount
- P = principal amount (initial investment)
- r = annual nominal interest rate (as a decimal, not in percentage)
- n = number of times the interest is compounded per
- t = number of years
In your recurring deposit, you use this formula to calculate the final amount with each installment, and at the end of the installments, you add them all up to get the final amount.
Think of RD Installments and Series of Principal Payments
Let’s take a simple example to understand this – suppose you start a recurring deposit for Rs. 47,000 per month for 2 years at 8.25% compounded quarterly. If you were to see this number as a standalone fixed deposit that you set up every month for 24 months, you could come up with a table like I have here. Before you get to the table, here is a brief explanation on the columns.
- Month: First column is simply the Month.
- Principal (P): Second column is P or principal investment which is going to be the same for 24 months,
- Rate of Interest (r). r is going to 8.25% divided by 100.
- 1+r/n: In our case, n is 4 since the interest is compounded quarterly, and 1+r/n is rate divided by compounding periods.
- Months Remaining. This is simply how far away from 2 years you are because that’s how much time your money will grow for.
- Months expressed in year: I’ve created a column for Months expressed in a year since that makes it easy to do the calculation in Excel.
- nt: 4 multiplied by how many months are remaining as expressed in year.
- (1+r/n)^nt. Rate of interest raised by the compounding factor.
- Amount (A). Finally, this is the amount you if you plug in the numbers in a row in the compound interest formula.
So, Rs. 47000 compounded quarterly for 2 years at 8.25% will yield Rs. 55,338.51 after two years. The last row contains the grand total which is what the RD will yield at the end of the time period.