How Banks calculate Interest ?
Savings account is the most widely used account to park your savings. The withdrawal flexibility is what makes it the most preferred account. And Fixed deposits are popular in terms of returns.
But most of us don’t know how the interest on these accounts is calculated.
Let’s look at how banks calculate Interest on Savings Accounts and Fixed Deposits to get a better understanding of the returns on the money saved in savings account.
Banks calculating Interest on Savings Account
According to the guidelines rolled out by the Reserve Bank of India in 2010, the interest on savings account is calculated on daily outstanding balance. It means that you earn interest on the bank balance you have at the end of each day.
The formula for the same is as follows,
Interest on savings account= Daily balance*Rate of interest* (No. of days/365)
Let’s try to understand it better with the help of an example.
Say, Mr. Krishnan has Rs. 100,000 in his account on Day 1. He withdraws Rs. 50,000 after 7 days. And then deposits Rs. 30,000 on the 14th day. And thereafter there are no transactions. Assuming the rate of interest is 4%, let’s look at the interest he has earned for the month of January.
| Date | Opening Balance | Deposit | Withdrawal | Outstanding |
| 1.1.2018 | 100,000 | – | – | 100,000 |
| 7.1.2018 | 100,000 | – | 50,000 | 50,000 |
| 14.1.2018 | 50,000 | 30,000 | – | 80,000 |
| 31.1.2018 | 80,000 | – | – | 80,000 |
Here, the interest will be calculated as follows,
From 1.1.2018- 6.1.2018 the outstanding balance was Rs. 100,000. Thus, the interest will be calculated on Rs. 100.000 for 7 days, which is,
100,000*4/100*7/365= 76.71
From 7.1.2018 to 14.1.2018 the outstanding balance was Rs. 50,000, upon which the interest shall be calculated for the period of 7 days,
50,000*4/100*7/365= 38.35
From 14.1.2018- 31.1.2018 the outstanding balance was Rs. 80,000, on which the interest for 18 days shall amount to,
80,000*4/100*18/365= 157.8
Thus, the total interest earned for the month of January will be,
76.71+38.35+157.8= 272.87
Interest earned for the month of January
| Outstanding Balance | No. of days | Interest Calculation | Interest earned |
| 100,000 | 7 | 100,000*4/100*7/365= 76.71 | 76.71 |
| 50,000 | 7 | 50,000*4/100*7/365= 38.35 | 38.35 |
| 80,000 | 18 | 80,000*4/100*18/365= 157.8 | 157.8 |
| Total interest earned | 272.87 | ||
Even though the interest is calculated on daily balance amount, it is credited to your account either half- yearly or quarterly based on your bank’s policy.
Calculation of Interest on Fixed Deposit & in case of Pre-mature Withdrawal
Fixed deposits generally pays higher interest than savings account. But it comes with a lock-in period. If you withdraw before the fixed tenure then a penalty is levied on the withdrawal, i.e. you will receive the amount after deduction of a small percentage of it, which generally ranges from 0.5%-1%.
The formula for calculation of interest is,
Interest= Principal*Rate of interest
Let’s understand this better with an example,
Ms. Shweta has invested Rs. 100,000 in fixed deposit for a period of 1 year, earning an interest of 8% p.a. . The 6 month interest rate is 6%. Premature withdrawal penalty is 0.5%.
Case I: Ms. Shweta withdraws after 1 year i.e. at maturity.
Case II: Ms. Shweta withdraws after 6 months i.e. premature withdrawal
In the first case, where Ms. Shweta completes the tenure of the F.D., she will earn,
Interest: 100,000*8%= 8000
Total Maturity value: 100,000+8000= Rs. 1,08,000
Thus, at the end of 1 year, Ms. Shweta will receive Rs. 1,08,000
In the second case, Ms. Shweta has withdrawn before the completing tenure of 1 year. She broke her F.D. after 6 months. In this case, the interest will be calculated differently.
Initially, when she had made the deposit, she had promised to keep the deposit for a period of 1 year for which the bank had offered 8% interest. But now that she is withdrawing earlier, the bank will pay her the revised interest which is applicable for a 6 month fixed deposit. In our case, it is 6%.
The point to note here is that because of premature withdrawal, the bank will not pay her interest at the rate of 8% for a period of 6 months. It will pay her interest applicable for a six month deposit period.
Along with it, the bank will also charge a penalty for breaking the promise, i.e. premature withdrawal, which is 0.5% in our example. Therefore, the effective interest that Ms. Shweta will receive is, 6% – 0.5% = 5.5%.
Let’s see the calculation,
Interest (6 months): 100,000*5.5%= 5500
Pre-Maturity Value (6 months): Rs. 1,05,500
Hence, it is not just the interest rate that should be considered while calculating returns on Fixed Deposit. It is also important to plan and calculate the effect on your overall return in case you need to break the Fixed Deposit for premature withdrawal.
There are some banks who offer premature withdrawal without charging any penalty. But even in those cases, you need to check the effective interest you will receive on premature withdrawal (just like in our example, where due to premature withdrawal the interest rate was revised from 8% to 6%).
TDS on Interest
TDS @ 10% is required to be deducted by the Bank on the Interest earned on Fixed Deposits. However, there are 2 exceptions to the same:-
- No TDS is required to be deducted on Interest earned on Savings Bank Account
- No TDS is required to be deducted if the Interest earned on Fixed Deposit is less than Rs. 10,000. This limit of Rs. 10,000 is per bank. Therefore, if a bank is paying interest on Fixed Deposit which is upwards of Rs. 10,000 (Cumulative on all FD’s), then they are required to deduct TDS @ 10%. However, in case one bank is paying cumulative interest during he whole year of Rs. 8,000 and the other is paying cumulative interest of Rs. 7,000 during the whole year – No TDS is required to be deducted as the interest payable by each bank less than Rs. 10,000.
TDS on Interest can also be reduced by filing an application in Form 15G/ Form 15H with the bank which has been explained here – Form 15G and Form 15H to reduce TDS on Interest.