Fixed deposits (FDs) have long been a popular choice amongst investors for offering assured returns and safety from market volatility. Among the different types of FDs available today, compounding FDs are an attractive option that offers higher returns with the power of compound interest. Let’s understand how they work and what benefits they offer to investors looking to grow their investments.
How Does a Compounding FD Work?
In the case of a compounding fixed deposit, the interest earned is periodically added to the principal instead of being paid out, which is known as the compounding effect. The interest typically compounds on a quarterly or annual basis. Over time, you earn interest not only on the original principal but also on interest accumulated from the past. As a result, your investment grows faster as compared to a simple interest FD, where interest is calculated solely on the initial principal.
For instance, you invest Rs 1,00,000 in a compounding FD with a 7 per cent interest rate, compounded quarterly. Interest for the first quarter will be calculated on the initial deposit of Rs 1,00,000. In the next quarter, interest will be calculated on Rs 1,01,750 (principal plus interest from the first quarter), and this process continues. With compounding, your investment can grow exponentially, especially over a longer tenure as interest is earned on both the principal and accumulated interest.
Benefits of Compounding FDs
- Higher returns: One of key advantages of a compounding FD is the potential for higher returns due to compound interest. It allows you the chance to grow your savings faster than a simple interest FD would.
- Safety and stability: Fixed deposits are one of the safest investment options available. Offering guaranteed returns and zero market risk, they are ideal for conservative investors or those looking to balance their portfolio.
- Flexible tenures: Compounding FDs are available for a variety of tenures, allowing you to choose a tenure that aligns with your short-term or long-term financial goals.
- Reinvestment opportunities: At the end of your FD tenure, you can reinvest the maturity amount in another compounding FD, further boosting your wealth-building efforts.
Tax Implications
The interest earned on fixed deposits is considered taxable income under the Income Tax Act. It is added to your total income and taxed according to your applicable income tax slab rate. However, FDs with a 5-year lock-in period qualify for tax benefits under Section 80C of the Income Tax Act. The amount invested in such FDs is eligible for a deduction up to Rs 1.5 lakh per annum. But the interest earned on these FDs is still taxable.
If you withdraw the FD before its maturity, banks usually impose a penalty, such as lowering the interest rate of the FD. The tax treatment remains the same, with TDS deducted as applicable. When filing your taxes, remember to declare the interest income from FDs under ‘Income from Other Sources.’ Also ensure that the TDS deducted by the bank is accounted for when filing your returns. If TDS has been deducted but your total taxable income falls below the taxable threshold, you can claim a refund for the excess TDS paid.
Compounding FDs are a powerful investment tool that can boost your returns by leveraging the benefits of compound interest. The key lies in understanding how it works so you can choose the right FD to meet your short or long-term goals.
The author is the AGM Communication at Bankbazaar.com. This article has been published as part of a special arrangement with BankBazaar.